Interest Rate Risk: What Does It Mean For Your Bond Investments?
During periods of interest rate volatility, investors are often left wondering what just happened to the price of their bond investments and why?
If you already own bond funds or are thinking about buying bond funds you should be aware of the impact that interest rates have on the value of your bond funds. Bonds can play a key part of a diversified portfolio and they’ll typically become a very important part of a portfolio as an investor is closing in on retirement or already retired.
The direction of interest rates has changed significantly over the long term. Though we have experienced a significant drop in interest rates since the early 1980s, over the very long term, there have been higher and lower cycles of interest rates (see chart below). Interest rates impact our everyday lives, from credit card rates to mortgages. This cycle can also impact less recognizable but very important parts of our investment portfolios.
Your Bond Fund On A Seesaw
So what happens to bond prices when interest rates move higher? Bonds and interest rates have an inverse relationship, meaning when interest rates rise, bond prices typically fall and when interest rates drop, bond prices usually increase. The visual is a seesaw as the illustration below shows.
Source: Invesco
There are a number of reasons why the price of a bond changes including issuer credit risk and bond prepayments. However, the direction of interest rates can be the most important influence of a bond’s value over time.
Let’s work through an example to explain the cause of this inverse relationship between bonds and interest rates. Let’s say you own a 10-year, $1,000 bond with a coupon rate of 5%. If interest rates rise, new bond issues might have coupon rates at 6%. This means an investor can earn more interest by buying a new bond instead of your 5% coupon bond. This reduces your bond’s value, causing you to possibly sell it a discounted price.
An Easy Way To Lose Money Investing In U.S. Government Bonds
This relationship of interest rates and bond prices moving in opposite directions is known as interest rate risk. This risk is common with most bonds, especially bonds with fixed rate coupons and even those insured by the U.S. government. Sometimes, investors misunderstand that if a bond is backed by the U.S. government, the bond cannot lose value. However, the U.S. government does not guarantee market values of bonds if sold prior to maturity. If an investor owns an individual bond until maturity, this interest rate-bond price fluctuation is not relevant as the investor should receive 100% of its original value.
Why Duration Matters When Bond Investing
Different types of bonds will fluctuate in value in their own way to changing interest rates. This is particularly true with a bond’s length of maturity. For example, long-term bonds fluctuate more in value than short-term bonds. This is called duration and is a measure of how much a bond’s price will likely change given a change in interest rates. The rule of thumb with duration is the longer the maturity of a bond, the more its value will change in relation to interest rate volatility.
To illustrate duration with a real world investing example, see the year-to-date 2019 returns for the two Vanguard bond funds below. The long-term bond fund holds bonds with an average maturity of 24 years while the short-term fund owns funds with an average maturity of 3 years.Thus far in 2019, when the 10-year U.S. Treasury bond rate dropped nearly 1.00%, the long-term bond rose far greater than the shorter-term bond fund primarily due to the difference in duration between the bond funds.
YTD Return (as of 9/24/19)
Vanguard Long-Term Bond Index Fund (VBLTX) 21%
Vanguard Short-Term Bond Index Fund (VBISX) 4%
Source: Morningstar
So What Should Bond Investors Do?
It’s not all doom and gloom if interest rates rise from current levels for a sustained period. A rising interest rate environment often signals a healthy and growing economy. Also, over time, investors in bond funds can do better in rising rate environments than in one where rates are stubbornly low (like now). This is because as bonds mature in a fund, the proceeds can be reinvested in newly issued bonds with higher rates. So while the value of a bond fund may drop in the short term because of rising rates, your return my rise over a longer period if you reinvest the higher income payments.
Interest rates will go up and down due to changing economic conditions and other hard to control circumstances. Instead of trying to guess the next move in interest rates, focus on what you can control which is understanding the interest rate and bond price seesawing effect. Also, identify bond fund investments that are appropriate for your portfolio by matching duration to your time horizon and how much volatility you can withstand and still sleep well at night.