Interest Rates

With interest rates in the United States expected to rise and the bull market in bonds expected to end, investors have a lot of questions. In this interview, DeAnne Steele, investment executive for the western United States at U.S. Trust, explains the basics of interest rates, bond investing and the effect rising rates have on investors and the economy.

Why do bond prices go down when rates rise?

Investors expect to buy a bond that is paying the current interest rate. Let’s say you bought a bond today that was issued at par, or face value ($100); it pays a coupon of $1 a year and so yields 1%. Then in a year, interest rates go up, and bond investors can get new bonds for a 2% yield. So, if you were to sell your bond, you would need to offer a 2% yield for every $100 in value. The only way to do that is for the price of your bond to go down. Your bond would then trade close to $99.02.

Interest rates and bond prices are negatively correlated. Although bonds fluctuate during the period between purchase and maturity, they mature at par value, or 100. This is why you should avoid having to sell bonds in a rising-rate environment. It would be much better to just let them mature.

Can you explain “duration”?

Duration is a measurement of a bond’s sensitivity to interest rate movements. It can be used to determine the expected percentage change in the price of the bond or bond portfolio given a 100-basis-point change. (There are 100 basis points in each percent.) The higher the duration, the more sensitive bonds are to interest rate movements. Generally, the longer you have until the bond matures, or the longer the average maturity of the bond portfolio, the larger the duration. For example, a duration of 5 means for every 1% change in interest rates, the bond price would change by about 5%.

Does a rising federal funds rate mean a loss in my bond portfolio?

Not necessarily. If you own all individual bonds and purchased them at a positive yield-to-maturity (total return, including coupon payments and price appreciation, is positive), then you avoid a loss over the holding period. Focusing on a positive yield to maturity is especially important when purchasing premium bonds, or those trading above 100. The chart “Return and Depreciation” below is an illustration showing that even with some depreciation in the price of the bond that was bought at a slight premium, the coupon is more than enough to highlight a positive return by maturity.

Are rising rates good or bad for investors?

As long as your duration isn’t too long and you have bonds coming due during the rising-rate environment, rising rates are good for investors. As you receive coupon payments and bonds mature, you can reinvest at a higher interest rate.

What are the risks?

Ideally, don’t sell a bond when rates start rising. Consider holding them until maturity. This helps avoid losses during the time between purchase and maturity, wherein a bond might dip in price due to rising rates.

Also, be careful of buying callable bonds, which can be redeemed before they reach maturity, at a premium. While they are less likely to be called during a rising-rate environment, it’s possible. And they could be called below the price you purchased them before you’ve had the opportunity to collect enough coupon payments to counter that decline. This is why it’s important to buy bonds with a positive yield to maturity and yield to call.

Also, be aware of the portfolio’s duration. If using a bond fund to provide adequate diversification, ensure that the duration is not longer than prudent, as bond funds don’t mature.

How do rising rates affect consumers?

Rising rates reflect an improving economy, a situation that has the potential to create inflation. The Fed raises rates to slow the economy and avoid too much inflation. So you can expect money market and bond rates to rise along with interest rates, putting more income in the hands of investors and consumers. It also means, however, that mortgage rates rise. The goal of the Fed is to slow the economy just enough to maintain an ideal inflation level — around 2% — but not enough to stop improvement.

Should we worry about the Fed going too far?

The bottom line is that rising rates signal an improving economy. As long as the yield curve is positively sloped, optimism continues. And rising rates are good for bond investors who are properly positioned.