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The Impact of Rising Interest Rates on Bonds

By Jane Young, CFP, EA

In addition to a tough year in the stock market, high inflation and rising interest rates have also resulted in the worst year on record for U.S. Bonds. The largest diversified bond funds are reporting year to date losses of around 15%, as of the end of September. We have never seen such large decreases in diversified investment grade bond funds.

This year has been unusually bad because the federal reserve is aggressively raising rates and we started at such a low level. Most of the damage has been done but bonds will continue falling while interest rates increase. Eventually rising interest rates should result in higher unemployment, a weaker economy and lower inflation. This will result in a pivot by the federal reserve and a rally in bonds.

Investing in bonds comes with two primary types of risk. The first is credit risk which represents the loss of capital if the issuing company or entity defaults on paying interest due on the bond. The second is interest rate risk which occurs when interest rates increase.

Fundamentally, increases in interest rates cause the value of bonds to drop. This is simply a function of supply and demand. New bonds are issued with higher returns and old bonds have rates that are below the market rate. This decreases demand for the older, lower paying bonds resulting in lower prices and capital losses. Losses may be temporary if bonds are held to maturity at which time they must be repaid in full.

Capital losses may be incurred if you sell a bond before maturity, or you own shares in a bond fund that experiences heavy redemptions and is forced to sell bonds within the fund at a loss. Additionally, bond funds and exchange traded funds must report the current market value of their holdings. The reported value probably represents a loss greater than you will actually experience.  Bond funds do not realize a loss on holdings that are held to maturity.

Interest rate risk hits long and intermediate term bond funds much harder than short-term bond funds. Short-term bonds will see a comparatively small price decrease because they can quickly replace the older, lower paying bonds with new bonds with a higher return.

Rising interest rates will benefit investors with longer time horizons. Bond funds pay dividends that are reinvested in new bonds paying higher interest rates and as bonds within the fund mature, new higher paying bonds are purchased. Over the long term the rise in interest rates should more than offset your losses.

Fixed income investments play an essential role in your portfolio. Similar to the stock portion of your portfolio, the fixed income portion should be diversified.  Money needed in the next few years should be invested in cash, certificates of deposit, and Treasury bills. Consider leaving money needed in the medium to long-term in short and intermediate term bonds funds.