What will happen to my bond funds when interest rates increase? This is a very common question from investors. The Federal Reserve has not increased interest rates since 2006—so long ago that most people don’t remember it.
Fortunately, as long as any future interest rate increases are slow and gradual, the answer to the question is, “Not much!” In fact, a slow and gradual increase in interest rates could be good for savers and investors, as long as the inflation rate does not increase faster than interest rates.
Why is “Not much!” the answer to this basic investing question? In a simplified explanation, as long as we have a positively sloped interest rate curve where longer-term bonds earn higher interest than shorter-term bonds, bond prices increase as they get closer to maturity and may do so enough to offset an interest rate increase. For example, over a five-year range, U.S. Treasury notes now earn about 1.75% for a five-year maturity, 1.50% for four years, 1.15% for three years, 0.70% for two years and 0.25% for one year. The year-over-year difference is 0.25%, 0.35%, 0.45% and 0.45% respectively. So when a five-year bond purchased today at 1.75% becomes a four-year bond one year from now, assuming interest stays the same, it will be priced higher than a new four-year bond priced at 1.50%. If interest rates go up 0.25%, pricing will be about the same.
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If we have two interest rate increases of 0.25% over the next 12 months, the effect on bond prices may be negligible. Even if rates go up 1% over the next 12 months, bond investors would eventually benefit from the higher interest rate income. If we have a 2% increase in interest rates in a 12-month time period, bond fund investors could lose 5% to 10% of principal value, but that would be recouped by higher interest income over time.
While trying to make this all sound simple, remember that the real measure of investment returns is relative to inflation. Buying a 15% CD in the early 1980s wasn’t very beneficial when inflation was 13%. Compare that with a 1.5% CD today when inflation is near zero: about the same. The real measure of investment returns is relative to inflation, so given our very low inflation rate of 1.76% per year over the last five years and 1.20% over the last three years and -0.23% over the last one year (negative inflation means deflation) ending June 30, earning 1.5% to 2.5% from bond funds still keeps investors ahead of inflation without stock market risk. Hope that helps you sleep well!
Enjoy these final summer days!
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