Interest Rates and Bond Duration Affect Total Returns

By Nathan Goodwin

While interest rates over the past several years have provided consumers with some of the lowest borrowing costs in history, investors and retirees needing income have struggled to find yield in investment grade bonds and bond funds. However, the interest rate environment may be changing. With the Federal Reserve suggesting that quantitative easing measures may come to an end in the near future, upward pressure in interest rates is to be expected. In fact, the speculation alone has already caused upward movement.

So why the recent uproar in fixed income markets? Won’t rising interest rates have a positive impact on bond yields?

Over time the answer to this is yes, but bond pricing itself may have a different story.

As interest rates rise, bond prices fall. Think about it like this; you buy a $1000 bond paying 3%. Two years later you decide to sell your bond when yields are now 5%. Will your3% bond sell? Sure, but not for $1000. You will have to sell at a discount to make up for the lower income received compared to current rates in the market.

Here are two points to think about:

  • If you buy individual bonds and hold them to maturity, rising rates will have no impact on the income you receive. At maturity, you will receive the par, or face value of the bond as anticipated. Just be aware that if you need to sell your bond before maturity it may be for a discount or premium depending upon interest rates in the market at that time.
  • Bond funds are popular because they provide diversity, essentially allowing investors to have ownership in many, potentially hundreds of bonds. This greatly lowers the impact of a bond default and also comes with professional management. These are good things. But because these funds don’t have a specific maturity date, the value or price per share will fluctuate inversely with interest rates. Investors will continue to receive interest payments from the bonds in the fund however. Additionally, as bonds within the fund mature and are replaced, higher interest rates should have a positive impact on the fund’s yield and interest payments.

Based on these principals of a rising interest rate environment, a logical question arises:

Will increases in bond fund yields keep up with the decline in share prices?

It depends on several factors, but a big determination will be the duration or time to maturity of the bonds in the fund. Generally speaking, the longer a bond’s duration, the more its price will be affected by interest rate changes. The relationship of yield to duration can also be an indicator. Funds whose yields exceed the average duration are still subject to interest rate changes, but may be more insulated to these changes than others.

This is not meant to say that changes are needed in your portfolio. Bonds can provide a predictable, dependable stream of income and are an important part of any portfolio. Those with a solid, long-term strategy that includes income may not need to reallocate, and may benefit from higher yields in the days ahead. It all depends on your individual circumstances, time horizon, objectives, and portfolio holdings.

With the economic climate changing, take this opportunity to review your investments and the allocations in each. If you have questions about these or other investment issues, feel free to contact us anytime.

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