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For bondholders, rising interest rates can have an upside

April 22, 2016

Conventional wisdom holds that interest rate increases are bad for bond portfolios. But in fact, depending on your time horizon, you can benefit from rising rates.

Three sources of return

Josh BarrickmanA bond's total return comes from interest income, changes in price, and interest earned on reinvested interest payments. "Compound interest is a significant boost to bond performance in the long run," said Joshua Barrickman, Vanguard's head of fixed income indexing for the Americas.

Still, bond prices seem to get the most attention, and they move in the opposite direction of yields. You can estimate a bond's price change by using duration—a measure of the sensitivity of bond, and bond mutual fund, prices to interest rate movements.

A chance for gain, if you can wait

Although a rate increase can initially pinch your portfolio, the opportunity to reinvest interest income (and the proceeds of maturing bonds) into higher-yielding bonds can work to your advantage over time.

The silver lining of higher yields

Cumulative rate of return

The silver lining of higher yields

Notes: This hypothetical example shows the impact for a generic intermediate-term bond fund if the Federal Reserve raised short-term interest rates by a quarter percentage point every January and July from 2016 through 2019. Intermediate-term rates are assumed to rise by the same amount.

Source: Vanguard.

Here's an example: Take an intermediate-term, investment-grade bond fund with a duration of 5.5 years and an initial yield of 2.25%. Assume rates rose by a quarter percentage point every January and July from 2016 through 2019, ending at 4.25%. As you can see in the chart, the cumulative total return would be negative through the first quarter of 2018, but by the end of the second quarter of 2023, it would be higher than if rates hadn't changed.

In part, that result reflects the power of compounding, as cash flow is reinvested at higher rates. This example is just one of many possible paths that rates could take. It's important to note that the pace and magnitude of rate increases would affect the time until breakeven.

As our example illustrates, if you can wait, rising rates can lift your return. "A helpful rule of thumb is that if your time horizon is longer than the duration of your bond fund, you stand to benefit," Mr. Barrickman said.

Bond bears growl less

Keep in mind, too, that bond bear markets historically have been marked by shallower valleys than those for stocks. A stock bear market is generally defined as a decline of 20% or more lasting at least two months. But a bond bear market usually means a period of any negative return, as happened in 2015. With yields so low, a small increase in interest rates led to a total return of –0.16% for the broad U.S. bond market (as measured by the Barclays U.S. Aggregate Bond Index).

The Fed has indicated, and Vanguard's economists anticipate, that the pace of future rate increases will be gradual. This is a more benign environment than one in which rates rise quickly, sharply, or both. Whether rates are expected to rise or fall, we recommend that you develop and stick with an asset allocation plan that fits your goals and time horizon.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest. Past performance is no guarantee of future results. Diversification does not ensure a profit or protect against a loss.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner, or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
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