Bonds in a rising rate world

How will a slowdown in the economy affect bond fund performance?
The Fed wants the economy to slow down a bit.​

In March, the Federal Reserve Board raised interest rates. The increase of one quarter of one percent was only the third time in a decade that rates have gone up. Many economists believe that more increases are coming. The Fed itself has mentioned the possibility of further rate increases this year.

There was a time when a rate increase went almost unnoticed. Not anymore. Rate increases lower bond values, and that has a few people concerned.

Rates regulate the economy

First some background. Why did the Fed raise rates? The short answer is our economy is growing, but it’s growing a little faster than the Fed thinks is ideal. We certainly want growth, but too much growth, too quickly, can be bad long term. It can lead to a spike in prices of goods, otherwise known as inflation.

So the Fed uses interest rates as a way to control the economy, as a gas pedal controls a car’s speed.

  • Accelerate: The lower you push the gas pedal, the more gas goes to the engine and the faster you go. The lower the Fed pushes interest rates, the more it revs up the economy. Low interest rates make borrowing more affordable. Businesses can build new factories, hire more workers, undertake more product development, and so on.
  • Decelerate: When you want to slow down a car, you lift off the gas pedal. That’s what the Fed did in March. Raising rates by ¼ point has the effect of reining in economic growth slightly.

What do rising rates mean for bonds and bond funds?

Raising rates causes bond values to drop. Interest rates and bond values move in opposite directions. So if you’ve been checking the value of your bond fund portfolio lately, you may see it has decreased.

What should bond fund investors do?

Bonds like it when interest rates go down. They like it when rates are stable. But they don’t like rising rates because often such moves cause bond values to drop.

Coming after such a long period where rates either declined or stayed flat, this may be the first time many investors see a decline in the value of their bond-oriented mutual funds. For a change, bond fund investors now have the wind in their face rather than at their backs.

Cause for worry? Not really, for two reasons.

  1. Bond funds likely play a key role in your investment portfolio. Bond values generally fluctuate less than stocks. They can dampen portfolio volatility over time. The lower volatility typically makes it easier to ride through market ups and downs. History shows that being invested through market cycles provides returns above those achieved by moving in and out of the market.
  2. Bond funds produce income. Most bond funds pay dividend income monthly. Some people chose to reinvest that income, while others receive it. Regardless of what you do, and regardless of the value of your bond fund, you will earn income even in a rising interest rate environment.

Imagine that you owned a piece of rental property. If the real estate cycle turned downward and the market value of your building fell, you wouldn’t tell your tenants their rents were going to be reduced. No, you’d continue to collect rent as usual.

The same is true of bond portfolios. They may fall in value, but they continue to pay income to shareholders. The value of a bond fund matters only if you plan to sell it, just like the value of rental property. If you’re not selling an asset, then the short-term value of the asset doesn’t factor into the moment — but the income does. Anyway, the longer you hold a bond investment, the greater the likelihood it will achieve principle appreciation.

Silver lining to rising rates

Because a portion of a bond-oriented mutual fund’s holdings are continuously maturing, the proceeds from matured bonds are reinvested at higher yields. That means your bond fund will pay out higher income in the years ahead.

You’ll see much in the mainstream press about interest rates in the next several months. If what you read raises questions, call our office. We’ll be happy to talk about how rate changes affect you.

Note: Any fixed income security sold prior to maturity may be subject to a substantial and taxable gain or loss. Securities America and its representatives do not provide tax or legal advice. Readers should consult their tax advisor, or legal counsel, for advice concerning their particular situation.