What Happens to Bond Investments When Interest Rates Go Up?
Consider this scenario:
Your friend Bob is concerned about what rising interest rates could do to his bond portfolio. He asks for your assistance in evaluating his bond holdings.
In his current bond portfolio, he has the following holdings:
- $10,000 face value AA rated municipal bond that matures in 3 months and is currently trading slightly below par.
- $15,000 of a mutual fund that holds investment grade, floating rate bonds.
- $20,000 of a short-term, investment grade corporate bond ETF which tracks a broad index of hundreds of bonds.
- $3,000 of a high yield bond ETF that tracks a high yield index of hundreds of bonds.
Bob has a long investment horizon ahead of him and he won’t need any of the funds invested in his bond portfolio for many years. To top it off, Bob also has another $100,000 of his portfolio invested in various equity market investments.
What advice would you give Bob on his bond portfolio if interest rates continue rising?
A. To liquidate his bond holdings, so his portfolio isn't harmed by rising interest rates
B. To sell the high yield bond ETF since the high yield sector will perform poorly in a rising rate environment
C. To sell the floating rate bond mutual fund since floating rate bonds will perform poorly in a rising rate environment
D. To not make any adjustments to his bond portfolio at this time
D is probably the best answer.
Liquidating all of his holdings would be an overreaction.
He will receive $10,000 (plus an interest payment on the bond) when the municipal bond matures in 3 months. This will happen regardless of whether interest rates increase in the next 3 months.
An increase in interest rates will mean that the coupon rates of the bonds in the floating rate mutual fund will adjust higher over time. This will help the performance of this fund, not hurt it.
Corporate bonds and high yield bonds typically have better performance than Treasury bonds during a rising rate environment. This is because more of the negative price impact of the rising rates is offset by the higher coupon payments of corporate bonds and high yield bonds.
When rates increase, newer bonds are issued with higher coupon payments. These newer bonds go into indexes to replace the older, lower coupon bonds when those lower coupon bonds mature.
The majority of the return for a bond investment comes from the coupon payments rather than price appreciation. Rising interest rates typically result in higher coupon payments over time, which is the largest driver of positive bond returns.
Lastly, having a portion of a portfolio invested in bonds typically reduces the overall volatility of the entire portfolio. Bonds are typically much less volatile than stocks and serve to manage the risk of the portfolio as a whole when stocks go through periods of volatility.
This quiz is intended for informational and illustrative purposes only. This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.
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