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Why rising rates are good for long-term investors

December 23, 2015

With the Fed holding steady on interest rates in September, many investors continue to wonder what to do when rates eventually rise.

Anish Patel"A rising-rate environment means a healthy economy and higher income opportunities, both of which are good for long-term investors," said Anish Patel, senior financial advisor for Vanguard Personal Advisor Services®. He suggests that diversifying broadly and sticking with high-quality bonds may be the most prudent course. "If your time horizon is longer than the duration of your bond fund, the higher cumulative income over the long run outweighs the front-end volatility from rising rates."

4 steps to handle rising rates

  1. Diversify broadly across maturities.
  2. Stick to high-quality bonds.
  3. Go global and expand the borders of your bond portfolio.
  4. Keep investment costs low.

Short-term pain may lead to long-term gain

While bond prices take a hit initially when rates rise, income reinvested at higher yields not only helps to recover bond losses, but can also compound into a significant portion of a bond fund's long-term total return. Mr. Patel gives the hypothetical example of a client with a 30-year time horizon, collecting 1.7% in yields today for the next 30 years.

"If interest rates jump by 2% to 3.7%, a diversified bond fund with an average duration of 5.3 years, may take about three years to recover. But the investor benefits from higher income for the next 27 years."

While we aren't likely to see the same scale of compounding as historically, reinvesting income in a bond fund will still generate greater earnings power than the stated yield because of the interest-on-interest return.

Rising rates aren't a secret

Still, as the Federal Reserve's anticipated rate lift-off draw closer, you may be hesitant to buy bonds.

"It shouldn't matter whether the Fed acts in November, in December, or even if it had done something in September," says Mr. Patel. "Market expectations of a rate rise are already priced into the yield curve and, thus, reflected in bond prices. It's the surprise to expectations that moves rates and bond values."

Another point to consider is that bond values across maturities and sectors typically don't move in unison.

"One of the best defenses against rising rates is maintaining a broadly diversified portfolio of global bonds. Blending imperfectly correlated assets across maturities and sovereignties helps dampen volatility," says Mr. Patel.

Rate increases likely slow and steady

Since the Fed announced unwinding of quantitative easing, its board members have consistently communicated that they intend to make more measured, staggered rate increases than in previous tightening cycles, especially given the fragility in global economic growth. A slow and steady rate hike path could help mitigate volatility risk.

What sets the path for rates—from the first hike to how fast and how far they go afterward—is economic fundamentals, specifically progress in the labor market and economic growth. Despite progress in U.S. labor markets, lower inflation, weaker global economic activity and diverging global monetary policies are likely to limit how much and how fast the Fed can raise rates.

"The important thing for investors to know is that there's no free lunch. If you're a long-term investor, riding through the intervening turbulence can help you build a bigger income cushion and amplify your portfolio's ability to buffer stock market volatility," says Mr. Patel.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • 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.
  • While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.
  • High-yield bonds generally have medium- and lower-range credit quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit quality ratings.
  • Diversification does not ensure a profit or protect against a loss.
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