One of the questions we're frequently asked is: “If interest rates are rising, should I still be invested in bonds?” The question arises because bond prices tend to fall as interest rates rise. You can think of the function this way: as interest rates rise, holders of bonds that have the old, lower rate will be required to sell (if they sell) at a lower price to attract a buyer in the new higher rate environment. This relationship gets a lot of press but greatly oversimplifies markets and the way bonds work. A reasoned analysis shows that the impact of rising rates is not as big a threat as many assume. More importantly, the rationale for holding bonds as part of a well-diversified portfolio is still very strong.
Nowhere to go but up? Many fear the bond market because interest rates are still low when compared to the rates of the last 30 years, and many believe that interest rates have nowhere to go but up. But how high they will go and how fast they will go are still up for debate. Even the new Federal Reserve Chairman, Jerome Powell, does not know how high-interest rates will go, despite the ‘certainty’ of many pundits. In fact, interest rates have already moved up from their historical lows, and it is unlikely that we will see rates rise quickly or to the levels that were seen in past cycles. Pimco, one of the largest bond managers in the world, believes that the equilibrium Fed funds rate, the rate at which the Fed is neither tightening nor easing, is between 2% and 2.5%, about two percentage points lower than the neutral rate in past cycles. Currently, the Federal Funds rate is at 1.75, not far from Pimco’s target.
The bond market is smart The bond market is smart. Buyers and sellers both already know the Fed is planning to raise rates. As a result, today’s bond prices already include an expectation for rising rates. For bond prices to change dramatically, we would need to see a surprise – a significant shift in market expectations for rising rates, or a significant change in the federal reserve policy toward rising rates. This makes the direction of bond prices much more difficult to predict than the simple ‘bond prices fall when interest rates rise’ relationship would imply.
The bond market is stable Even if we did see such a surprise, bonds are far more stable than the stock market, so it is important to put a bond decline into perspective. The typical ‘decline in the bond market’ is still far less than a decline in the stock market. In fact, an upward surprise in interest rates, or a quickening of the pace of interest rate hikes by the Federal Reserve could impact the stock market far more than the bond market.
The bond market is self-healing It is also important to remember that the bond market is self-healing. Rising interest rates put pressure on bond prices today, but the bondholder benefits from the higher interest rate going forward. Further, once the bond matures the investor can invest in a new bond at a higher interest rate, increasing his overall return.
The bond market is counter-cyclical The bottom line is that bonds play an important role in a well-diversified portfolio – even in a rising interest rate environment. Bonds tend to be counter-cyclical, performing comparatively well during recessions. Investors who fear bonds because of rising interest rates can do significant damage by moving bond assets to pro-cyclical investments that will fall during a recession. There are simply few investments that behave like bonds, and their stability and counter-cyclical behavior provides important stability to a portfolio, especially the portfolio of the retiree. A well-diversified portfolio is one that takes advantage of the differences in behavior of bonds when compared to stocks.