What happens when interest rates rise?
Since the Great Recession of 2008, many investors have felt more comfortable in bonds than in stocks. The shift away from equities and into bonds was substantial and significant: Since the end of 2007, markets have seen over $1 trillion of net inflows to bond funds.1 Bonds are perceived as a safe haven, lower in volatility than stocks and a source of steady income for retirees. Given the emotional turmoil investors experienced with the S&P 500 declining 55% between March of 2007 and March of 2009, this flight to safety was understandable.
Bond investors have benefited from a bull market for the past few decades as interest rates peaked in double digit figures in 1980 and continued to decline through this past year. The yield on the 10-year Treasury fell to less than 2% as recently April of 2013. Since the market value of bonds is inversely related to the directional move of interest rates, the annualized return on the average core bond product over the past few years was nearly 7%.2 In short, as interest rates fell, the value of bonds rose and investors benefited.
So what happens when interest rates rise?
Currently, the Federal Reserve supports a low-rate environment in the face of slow yet deliberate economic improvement in the U.S. Federal officials have stated that 6.5% unemployment and 2.5% inflation are targets that, once reached, may trigger the Federal Reserve to begin a multistep process to raise interest rates. The caveat to consider is that this target is merely a guide. It does not provide an exact date when the Federal Reserve will begin to raise interest rates. The challenge facing investors is to consider how future interest rate increases might impact their portfolios.
Hindsight is 20/20. A rapid increase in rates from 1993 to 1994 saw the 10-year Treasury yield increase 2.9% in 327 days.3 Twenty years ago, the economy was heating up, and raising rates was meant to pre-empt rising inflation. The result was a shock to the bond market, and the average intermediate investment grade bond fund lost 5.2%.4
A more gradual cycle of interest rate increases may act as a drag on bond returns rather than a shock. Recently, a less dramatic response to rising interest rates occurred when the 10-year Treasury rate rose from 3.1% to 5.3% from June 2003 to June 2007. During this period, the average intermediate investment grade bond fund returned an annualized 2.1%.5
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What is your level of interest rate risk?
Investors need to understand the level of interest-rate risk they carry in their portfolios. Funds with higher durations carry more risk than funds with lower durations. Duration is the most commonly used measure of risk in bond investing. Duration incorporates a bond’s yield, coupon, final maturity, and call features into one number, expressed in years, that indicates how price-sensitive a bond or portfolio is to changes in interest rates. For example, the price of a bond with an effective duration of five years will rise (fall) 5% for every 1% decrease (increase) in its yield. Interest rates directly affect bond yields, and as a result, the longer a bond’s duration, the more sensitive its price is to changes in interest rates.
Now is the time to proactively review your portfolio with your financial advisor in preparation for the possibility that interest rates will shift higher. Discuss whether it is appropriate to shorten duration, seek out higher quality, or increase liquidity to prepare for higher rates over the next few years.
Footnotes: 1,2,3,4,5 Matthew Lemieux , “Getting Ready For Rising Rates,” May 1, 2013 issue of OnWallStreet.
This article was written by Andrea Paff, first vice president and a financial advisor with the Droster Team at RBC Wealth Management in Madison. It was prepared by or in cooperation with RBC Wealth Management. The information included in this article is not intended to be used as the primary basis for making investment decisions nor should it be construed as a recommendation to buy or sell any specific security. RBC Wealth Management does not endorse this organization or publication. Consult your investment professional for additional information and guidance. RBC Wealth Management does not provide tax or legal advice.
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