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What should investors do about the possibility of higher interest rates?

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John Wood
John Wood
5 months ago

The intrinsic value of a bond (or bond fund) is a simple proposition, and the interim impact of rate increases can obscure that fact at times.

Take, as an example, the Vanguard Intermediate Term Corpororate Bond Index Fund (VICSX). It’s Average Coupon is 3.4%, and its Average Effective Maturity is 7.6 years. So, the fund will receive an average of $34 of annual income per bond held for an average of 7.6 years, and then receive its $1,000 of principal per bond. That’s the intrinsic value of the fund.

The market pricing effects, however, can be seen in the Average Yield to Maturity (4.3%), and the Duration (6.4 years, suggesting a 6.4% price movement on a 1% move in interest rates). The share price has also dropped from about $26 to $22 since the bottoming of rates in 2021. These are the pricing impacts of the current, rising rate environment.

However, assuming that the bond manager doesn’t torpedo a fund with bad trading (presumably, less likely to happen in an index fund), the investor should receive the intrinsic value of the investment over time, regardless of market pricing movements.

The inverse relationship between interest rates and bond prices is relevant with regard the current pricing of the bonds, and the Capital Gains or Losses that would result for sales before their maturity dates, but the intrinsic returns are essentially assured, if the bonds are held to maturity, and presuming no major credit defaults.

All of which is to say that I’m not locking in losses by selling my existing bond fund holdings that may have lost money on paper at the moment (and I hope the bond fun managers aren’t as well).

Jackie
Jackie
8 months ago

Stay in equities and cash

peterfell66
peterfell66
8 months ago

Buy more I-series savings bond on Treasurydirect.gov (currently, Q1 2022, paying 7.12%!) 😉

Mike Zaccardi
Mike Zaccardi
1 year ago

Fixed-income investors should be excited!

Didn’t expect to read that, did you?

Of course bond prices fall when rates rise, all else equal, but with a bond fund, new higher-yielding holdings slowly replace lower-yielding maturing bonds.

Wouldn’t it be great to have an environment 10+ years down the line when you can invest in an aggregate bond fund and earn a positive real yield of perhaps 2-3% like the good ole days? If you periodically invest in bonds now, maybe you will stand to benefit in that scenario.

Coming back down to the reality of today, bond investors have to step out on the risk spectrum in search of decent yields. Emerging market bonds, US high yield debt, floating-rate bonds–all are popular options.

You can also invest in Series I bonds or even Series EE bonds that have virtually no risk.

High dividend stocks and closed-end funds (which use leverage to really juice the yield) may seem like decent options, but a year’s worth of dividends can be wiped away after a couple days’ trading.

Jerry Pinkard
Jerry Pinkard
5 months ago
Reply to  Mike Zaccardi

I agree I bonds are a great investment. Unfortunately, it is limited to $10k per year per person. I do not know enough on some of his recommendations to comment, but US HY corporate debt seems especially risky right now. HY usually does poorly in a recession and many experts are predicting a recession is highly likely in the near term. In a recession, many HY debtors will default on their loans, diluting the value of this investment. I was a long time holder of HY corporate fund who finally decided to take my risk in the equity side of my portfolio.

Philip Stein
Philip Stein
1 year ago
Reply to  Mike Zaccardi

I agree with Mike. I currently own short- to intermediate-term bond funds and I welcome the prospect of higher interest rates going forward. I don’t own these funds for potential capital gains, but for the income they provide. Declines in NAV when rates rise don’t concern me since I plan to hold these funds for the long-term.

Richard Gore
Richard Gore
1 year ago

I don’t think you should do anything. I can’t predict future interest rates so I don’t try.

Carl Book
Carl Book
1 year ago

Stay the heck away from long term bonds. They will get killed if rates rise.

Rick Connor
Rick Connor
1 year ago

Not much, and I’m a little worried that I should be doing more. Most of my bonds are in a Vanguard Total Bond funds, and I’m thinking of shortening that holding. I’m still not at the point where I need to touch retirement savings, but that is getting closer.

Marc Bisbal Arias
Marc Bisbal Arias
1 year ago

There are several things investors can do about potential higher rates. One would be to ignore the issue altogether. I’ve seen people argue that higher rates is what bondholders should hope for, because they’ll receive higher interest payments. But it could be a costly proposition if the fall in bonds’ prices are larger than the benefits from higher rates. This is the option I’d be most wary of.

Another option would be to invest in bonds with short maturities. These bonds would be less affected to increases in rates. However, they will offer lower returns too.

Bonds with higher coupons are also less affected by higher rates. But they can have other risks, such as a higher probability of default.

Investors might just not hold any bonds. While this erases the risk of rising rates completely, it also comes at the expense of earning minimal (if any) returns in a bank account or similar products.

Finally, one could switch from investing in bond funds to individual bonds. If an investor plans to hold the bond until maturity, the price of the bond will not fall because they won’t sell it. Bond funds are marked-to-market daily so if rates go up, the price of the fund will go down. Nonetheless, buying a bond directly, rather than indirectly through a fund, has disadvantages. First, it can be more costly and complicated. Second, owning a handful of bonds offers less diversification benefits than a bond fund. And last, but not least, the nominal value of the individual bonds will be worth less if rates and inflation are higher.

There are pros and cons for each of these scenarios. There could be other options. The takeaway is that we must make the trade-off that we’re comfortable with, which can in turn depend on our risk tolerance, expectations, and preferences.

EDIT:

As Joseph told me on Twitter, I didn’t mean to say individual bonds aren’t marked-to-market. I meant to say that by investing in an individual bond, if held to maturity, there will be no loss of principal. But bond fund managers can trade and realize losses.

Last edited 1 year ago by Marc Bisbal Arias
Sanjib Saha
Sanjib Saha
1 year ago

For holding until maturity, one doesn’t need to own individual bonds. There are target-maturity bond funds to serve the same purpose (e.g., Invesco Bulletshare ETFs, iBonds, even some closed-end funds). These invest in multiple bonds that mature around the same “bullet” date.

Last edited 1 year ago by Sanjib Saha
Marc Bisbal Arias
Marc Bisbal Arias
1 year ago
Reply to  Sanjib Saha

Interesting, I wasn’t aware. Thank you for sharing.

Sanjib Saha
Sanjib Saha
1 year ago

I’m simply limiting my bond investments to shorter term and high quality. I have no idea when rates will go up, but the current rates are not worth taking any maturity or credit quality risks. I’m also trimming stock exposure as the market keeps on hitting new highs. I love mechanical rebalancing – takes emotion out of the picture.

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