Rising Interest Rates are All Bad News for Income Investors
The Federal Reserve made news today by raising interest rates ¼ of 1%. No big surprise there, but they did surprise the market by suggesting that Fed members were starting to forecast a need for additional hikes over the next 6 months. The stock and bond markets were not expecting that, so interest rates jumped today (and bonds fell) on the news.
The move in interest rates on the 10 year Treasury bond (which are actually set by the market, not the Fed) over the past month has been dramatic. As low as 1.75% pre-election – the 10 year bond is now yielding 2.5%. The 10 year is important because all kinds of interest rates are pegged to it, from annuities to mortgages and more. But are higher rates good or bad for investors?
Hard to say, as it can be very hard to make fixed income investors happy.
On the one hand, as retirees everywhere know, low interest rates are a real drag. Its hard to generate safe, reliable income in retirement with bond yields below 2% and bank CD’s paying less than 1%.
On the other hand, if rates move higher, bond investors stand to lose money (at least in the short run). For those not familiar with the math, just think that a 10 year bond paying 1.75% is obviously less attractive than a 10 year bond paying 2.5% – so investors will pay less for existing bonds when conditions cause the market to expect rate increases.
So do we want higher rates, or not?
It depends on how patient you are willing to be as an investor.
When interest rates rise, the immediate reaction by the fixed income part of your portfolio will be a decrease in value. However, that fixed income mutual fund or ETF is constantly changing. Among its thousands of bond holdings, some are maturing every day. As each bond matures, the principle is paid back (in full unless the issuer defaulted) into the fund. Those proceeds are then reinvested into new bonds at the new higher interest rates.
If rates remain at new higher levels, the investor will soon be better off, as the interest being paid out by the fund will increase as more and more older bonds with lower interest rates are replaced by newer bonds with higher interest rates. In fact, Vanguard did an interesting study recently that showed that bond investors would actually be far better off in a rising interest rate environment over a 10 year period than if interest rates remained at ultra low levels and did not change. Losses from rising rates, in this study, were more than offset by rising income for investors willing to wait the process out.
In the short run, it is somewhat painful watching the bond portion of your portfolio get shellacked by rising interest rates. But there is assurance in the knowledge that this is a much more mathematical process than the emotion driven swings of the stock market. We know that rising interest rates ultimately means more money being paid by your bonds. The math ultimately works in your favor. It just takes some time to work its way through the system.
Since higher rates are good for fixed income and conservative investors, and you would think that investors would thus welcome the change. But thanks to the short-term sacrifice involved, investors can be forgiven for thinking like St Augustine “Oh, Master, make me chaste and celibate – but not yet”
Note: Jim is a Certified Financial Planner and owner of Financial Pathway Advisors, LLC, a financial planning firm and Registered Investment Advisor with offices in Bridgewater, Flanders, and Cranbury New Jersey.