Vanguard - Bonds and rates: The reality behind the headlines

Vanguard - Bonds and rates: The reality behind the headlines

Vanguard | 03/05/2010

Moves in interest rates are notoriously hard to predict, but that hasn't stopped many market observers from declaring that rates are headed up in the near future. If the predictions are right and rates do climb, you're sure to see headlines about how such an environment is bad for bond investors.

As is so often the case, the headlines won't tell the whole story. It's true that a general rise in rates will cause bond prices to fall and thus reduce the returns of most bond funds in the short term. But the higher rates can boost returns for long-term bond investors who stay disciplined about reinvesting their interest income. The reality is that if you're steadily reinvesting interest income, rising interest rates can be good news.

See for yourself

The interactive graphic below gives you some perspective on why holding on to a bond fund in a rising-rate environment can pay off over time. The hypothetical scenario assumes that interest rates rose by 1 percentage point in each of the first 2 years, climbing from 4% to 6%.

In the first year, the bond fund's total return—price change plus reinvested income—would be –0.8%. But as interest earnings and any maturing bonds are reinvested at higher yields, the fund's return would rise. After 7 years, the bond fund would have produced an average annual total return higher than the returns for two other hypothetical scenarios shown—one in which rates fell and another in which rates remained constant. Please note: These hypothetical returns are not meant to illustrate the returns of any particular investment, nor do they consider the effect of inflation.

How rates affect bond prices and yields

Interest rates influence the yield, or the annualized rate of interest income, provided by bonds and bond funds. Interest rates also influence bond prices. When rates go up, the price of a previously issued bond can fall. That's because you wouldn't pay full price for a bond with a face value of $1,000 and a yield of 4% if you could get a new bond for the same price yielding 5%.

In the short term, bond fund returns suffer because of this price drop. But then the benefit of higher interest income starts to kick in. New bonds purchased by the fund can provide higher yields. Investors can earn more by staying invested and reinvesting interest income at higher yields. And over time, the effect of compounding—earning interest on interest—can more than compensate for an initial price decline.

Keeping rate moves in perspective

Why not try to jump out of bonds before rates climb and then get back in after rates have settled? This market-timing approach sounds good in theory, but the reality is that it can be a losing strategy because of the difficulty of predicting rate moves.

Focusing on interest rate moves and short-term changes in bond prices can be counterproductive. Over the long term, it's interest income—and the reinvestment of that income—that accounts for the largest portion of total returns for many bond funds. The impact of price fluctuations can be more than offset by staying invested and reinvesting income.

So if you're holding bond funds as part of your client’s long-term asset allocation, a rise in rates probably shouldn't prompt you to make any changes. Indeed, your client can benefit by sticking with the bond allocation that's right for them.

Notes:

• All investments are subject to risk. Investments in bonds and bond funds are subject to interest rate, credit, and inflation risk.
• Past performance is not a guarantee of future results.