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Understanding Bonds in a Rising Interest Rate Environment

| October 28, 2022
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In a situation that would have Sir Isaac Newton rolling in his grave, we’re disproving gravity: what went down (interest rates) must come back up.

In this graph, the highlighted years are periods of rising U.S. federal funds rate, representing the most recent cycles in which the Federal Reserve increased interest rates over a complete cycle. The year 2013 is circled for the so-called taper tantrum, in which the 10-year U.S. Treasury yield increased by approximately 150 basis points after the Federal Reserve mentioned the possibility of gradually reducing the quantitative easing purchase program.

 

Source: Bloomberg Index Services Ltd. The U.S. fixed income market is represented by the Bloomberg U.S. Aggregate Bond Index. *Includes prepayment factor on securitized products.

When Interest Rates Rise

When the U.S. Federal Reserve raises short-term interest rates, it’s referred to as “Fed tightening.” Technically, the Fed is targeting short-term overnight interest rates. Longer-term interest rates, such as home mortgage rates or 10-year U.S. Treasury yields, are usually driven by investors’ expectations for economic growth and inflation. The highlighted years on the graph above indicate the years when short-term interest rates were increased. While there were periods of price declines and negative total return, these periods were short and were followed by positive returns. Past performance cannot guarantee future results.

Why do bond prices decline when interest rates rise?

If you hold a bond to maturity, the issuer pays interest, also known as a coupon, periodically and returns the principal on the maturity date. Let’s assume the coupon rate of a bond is 5%. When interest rates rise, new bonds will be issued with a higher coupon rate, which means the investor will receive higher payments. That means the old bond with the 5% coupon rate isn’t as desirable. For that bond to be attractive to investors, it must be priced at a discount to the new higher-rate bonds. Bond mutual funds are subject to the same fluctuations.

Rising Rates Can Have A Silver Lining For Bond Investors

When the Fed raises short-term interest rates in a measured way, known as Fed tightening, this can be good news for long-term investors exposed to bonds.

  • Bonds remain a critical component of a diversified portfolio as they help dampen the volatility of stock exposure.

  • During periods of rising interest rates, regular coupon payments and reinvestment in new higher-yielding bonds help cushion the impact of declining prices for existing bonds and can boost total return over time.

  • During past periods of Fed tightening, total returns for bonds, as measured by the Bloomberg U.S. Aggregate Bond Index, were typically benign and eventually recovered.

 

Any opinions are those of Andrew Ulvestad and not necessarily those of Raymond James. Expressions of opinion are as of 10/21/22 and are subject to change without notice. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation.

There are special risks associated with investing with bonds such as interest rate risk, market risk, call risk, prepayment risk, credit risk, reinvestment risk, and unique tax consequences. To learn more about these risks and the suitability of these bonds for you, please consult with your financial advisor about your individual situation.

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