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See Ya, 0%—What Rising Rates Mean for Bond Investments

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June 8, 2015
Farewell to the interest rate deep freeze?

It’s not if, but when. So goes the handicapping of a Federal Reserve interest rate hike. No one, including bond investors, is quite sure when the Fed will launch the first increase for U.S. rates since 2006. But a bias toward tighter policy—even among slow-moving Fed members—is largely considered a lock at this point.

So while global growth snags leave most other central banks loosening their monetary policy as mid-2015 nears—including Europe’s and China’s—the U.S. appears willing to nudge short-term rates up from the unprecedented, effectively 0% short-term Fed funds target that’s been a fixture in fixed income markets. The Fed funds rate sets the short-term borrowing costs between banks. Rates along the yield curve adjust accordingly, and that means bond investors need to rethink their sensitivity to rising rates. In fact, bond and stock investors alike should remain on rate-watch.

Federal Reserve dot plot of member forecasts

FIGURE 1: PLOT THICKENS? The Fed’s low-production but powerful “dot plot” graphic has become a go-to indicator in the financial press. This sprinkling of member forecasts for the federal funds rate target, last released in March, revealed pared expectations. The median federal funds rate, now near zero, was expected to rise to 0.625% by the end of 2015 instead of 1.125% as predicted in December. For 2016, the median rate is expected to end at 1.875% instead of the 2.5% that was forecast earlier. Source: Federal Reserve. For illustrative purposes only.

What’s It Mean for Bonds?

The Fed watch has been a challenge for investors. Rumblings about rate moves have dominated financial markets for months that turned into years—and still no Fed move to date. With the rest of the world paying a dismal interest rate on deposits and debt compared to the thin U.S. offering—plus U.S. stability a beacon in the wake of Greece uncertainty—global demand for U.S. bonds remained relatively strong.

Higher demand for bonds pushes up their prices and holds down their yields (or rates). Consider that a sizable portion of the globe’s sovereign debt trades at a negative yield, notes Craig Laffman, TD Ameritrade’s director for fixed income trading and syndicate.

When the globe wants U.S. bonds, market action sometimes works against the Fed’s higher-rate “bias” and challenges bond investors who are weighing market rate moves against actual Fed policy. But Laffman emphasizes: expectations for Fed moves will show up in the bond market in advance of actual policy change.

If you’re thinking about buying bonds or bond funds, or have recently added a fixed-income component to your diversified portfolio, you need to be aware of the potential impact from rising rates on your holdings. And if your stock holdings include financial shares, the implications for banks’ own bond holdings and bond trading may also matter to you.

If interest rates go up and you need to sell your bonds before they mature, be aware that their value may have gone down and you may have to sell at a loss, all else being equal. If you buy a bond and hold onto it until it matures, which many investors do, rising rates won’t change the income payments you receive. At maturity, you get back par, which is the face value of the bond. But don’t forget about credit or default risk—the risk that an issuer can’t honor its principal and interest payment obligations. Government-issued bonds carry relatively low default risk, but a rising-rate environment could compromise the fiscal health of the companies who are making the payments on the corporate bonds you’re exposed to.

Let’s explain that a bit more. The price of an individual bond will fluctuate in the opposite direction from interest rates. For example, if you purchase a $10,000 bond at par value (or face value) with a coupon (yield) of 4%, your annual income is $400. If interest rates rise and a newly issued bond with an identical rating (meaning competing with the one you already own) pays 4.5%, the value of your bond declines to $8,889. So now if you sell your bond, the buyer, who will be receiving $400 in interest per year, will have a yield of 4.5% on his or her investment to match the prevailing market rate.

Few folks like to think about a value drop of 11%, but if you don’t need to sell your $10,000 bond, it is designed to continue to pay you that $400 in annual income, plus your return of $10,000 when the bond matures.

Also, the lower a bond’s “coupon” rate, the more sensitive its price to changes in rates. Coupon is the amount of interest due, and when. Other features can have an effect as well. For example, a variable-rate bond probably won’t lose as much value as a fixed-rate security.

Not All Created Equal

There’s an important distinction between bonds and bond funds, especially in a changing interest rate climate. Bond funds don't have a set maturity date. You may find that when you need to get your money back, you have to sell your piece of the fund, and that piece may fetch a lower price than you initially paid. The value of bond funds can be greatly influenced by inflows and outflows, too. That means liquidity can strongly affect bond funds’ fate.

Of course, while the price of your bond fund might drop if interest rates rise, there’s another source of potential returns for your bond fund: interest payments. The returns from a "passive" portfolio of fixed income investments come almost exclusively from returns on interest payments from individual bonds—reinvested and compounded over time.

Now, as the Securities Industry and Financial Markets Association (SIFMA) points out, changes in interest rates don’t affect all bonds equally. Generally speaking, the longer the bond’s maturity, the greater the impact of changing interest rates. Because of its longer exposure, or duration, a 10-year maturity will usually lose more of its value if rates go up than a 2-year note.

Bond funds with shorter durations will typically be less sensitive to increases in interest rates, and it is more probable that you would recover your initial investment sooner if interest rates rise as compared to funds with longer durations. However, funds with shorter durations typically have lower yields.

This Is the Year

Fedspeak will remain a critical market driver in the coming weeks and months. A speech from Janet Yellen in late May spooked the stock and bond markets when the Fed chief indicated the first move would be this year. No surprise, perhaps, but some on Wall Street believed a string of spotty consumer spending data and low inflation readings arguably buys the Fed more time. Anticipating that the unprecedented economic juice might remain, investors drove stock indexes to fresh record highs in May. Stock and bond investors know this “artificial” prop can’t remain forever, but they want to make sure the Fed nails it with pacing and timing—thus the nerves and uncertainty.

“A September rate hike appears to be currently up for debate. Nonetheless, progress towards the committee's dual objectives [stable prices and maximum employment] continues to be made,” says Andrew Labelle, economist with TD Economics. “We expect that over the next several months, firming data will provide enough evidence for the Federal Open Market Committee, which would prefer to raise rates this year, to do so by September.”

“For the Fed, it’s more important to be right than early—the risk of raising too soon exceeds waiting too long,” adds Laffman. “For the average bond investor, it's more important to take advantage of strong asset prices and reallocate ahead of the Fed’s timing.”

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