Rising interest rates have been a concern among bond investors for many years. The Federal Reserve is signaling that they remain on track to raise interest rates in 2015, which means that the wait may be finally over.
While the Fed may raise short-term interest rates in 2015, longer-term rates are driven by market factors that are difficult to predict with consistency. It is easy to assume that rates must go up because they are currently so low, but that would be a mistake. There are three plausible scenarios for interest rates: rates increase, decrease, or remain roughly the same.
There are several factors keeping Treasury yields low other than Fed policy such as comparatively attractive yields relative to other major bond markets such as Germany and Japan, low inflation expectations, and less debt issuance as a result of the shrinking US federal budget deficit.
Trying to predict interest rate movements involves taking unnecessary risk with the portion of your portfolio that should be the least risky. The primary purpose of your bond allocation is to decrease the volatility of a portfolio. As part of a balanced portfolio, bonds provide diversification and capital preservation benefits, while stocks are the main source of risk and return over the long run.
Even if bonds experience temporary losses, the worst bond markets are not as severe as the worst stock markets. The graphic below illustrates this point using returns since 1990.
Regardless of the historical time period you choose, annual losses from bonds have been minimal because the higher income earned as the result of rising interest rates offsets the negative impact on price. For that reason, rising interest rates are a good thing for long-term investors. Consider the scenario below that depicts the impact of a one percentage point increase in yield on the total return of a bond.
The above example uses the Barclays Aggregate Bond Index, which has a yield of 2.39% and duration of 5.63 as of June 30, 2015. For ease of presentation, this analysis assumes a one-time parallel shift in yields and then no further fluctuation in interest rate. In addition, we assume that all income received is reinvested, which is important because reinvesting income at higher rates helps offset the losses in the initial hike year and increases the total return of the bond portfolio over time.
The same holds true for a more dramatic rate hike scenario of three percentage points, although recovering from the initial loss takes a little longer. An interest rate hike of this magnitude has occurred only twice in history (1980 and 1981), but serves as a sort of worst-case scenario analysis.
As you can see, the Year 1 return is dramatically worse with a larger interest rate increase – in fact, it would be the second worst 12-month return for the U.S. bond market ever. Although the initial loss is more dramatic than the initial example above, the end result is the same: higher yields benefit investors in the long run by providing higher returns.
The focus on changes in interest rates – known as interest rate risk – is just one of the many factors that affect bond prices. Building a diversified bond portfolio also requires consideration for factors such as inflation and credit fundamentals, among other things.
With regards to rising interest rates, here are the key points to remember:
- The primary purpose of bonds are to decrease the volatility of the portfolio. Equities should be the main source of risk and return over the long run.
- Expectations of rising interest rates are legitimate, but the worst bond markets are far less severe than the worst stock markets.
- Rising interest rates are a good thing for long-term investors. The ability to reinvest interest and principal payments at higher yields help offset losses provides higher returns over time. This applies to both individual bonds and bond funds.
All index data comes from FactSet.
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This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.
This article originally appeared on Forbes.com.