Bonds 102: Rising Interest Rates may Benefit Bonds
- How bond investors can benefit from rising interest rates
- Why a disciplined investment approach is important to bond investing
- The role of duration when rates are rising
How can bond investors benefit from rising interest rates?
Rising interest rates can be good for bond investors as they can take advantage of the higher rates to boost their portfolios’ long-term growth potential.
For example, say a bond investor receives coupon payments from an existing bond holding, or one of their bond holdings matures. The investor decides to reinvest this money back into the bond market.
If rates are rising, the investor will be rewarded with a higher yield. By contrast, if the money was reinvested in a declining rate environment, the investor would be offered a lower yield.
In a rising rate environment, it generally makes sense to invest in bonds with shorter times to maturity – also referred to as lower duration – because they are less sensitive to rate changes.
Why is a disciplined investment approach important to bond investing?
Much of how bond investors may be affected by rising rates depends on how they are invested – be it through direct investment in individual bonds, through a passive fund, or through a fund actively managed by a professional investor.
Investment approaches and implications
- Direct investment
Investors holding individual bonds (or directly) can avoid realizing losses of principal during periods of rising rates by simply holding their bonds until maturity. They will continue to receive coupon payments as well as investment principal at maturity when they have the option to reinvest their money in higher yielding bonds. - Passive bond fund (e.g., through Exchange Traded Funds)
As interest rates rise and the performance of the bond market drops, so too will that track bond indices. Investors have the option of selling their shares which locks in capital losses, or holding on until performance recovers. - Active bond fund
Investing with an active bond manager can be beneficial when interest rates are rising. Active managers, particularly those who have the flexibility to invest across various sectors of the global bond market, seek to navigate rising rates and other market conditions to find attractive opportunities for investors. For example, rates may be rising in one country, but not in another.
Of course, there is the potential that the active managers won’t achieve their objectives and will underperform market indexes.
What is the role of duration when rates are rising?
Generally, bonds with a longer duration are more sensitive to interest rate changes. This means that when rates rise, the price of longer-duration bonds tends to fall further than shorter-duration bonds.
Investors looking to reduce interest rate sensitivity in their portfolio during a rising rate environment may be tempted to reduce bond holdings – especially holdings of bonds with long durations.
However, investors need to be cautious when it comes to stripping duration out of their portfolio. Long-duration investments are an important part of overall portfolio diversification and may provide the buffer an investor needs if market conditions change.
If the investor is satisfied with the level of portfolio risk overall, it may make sense to keep things as they are.
Disclosures
A word about risk: All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed.
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