For the past couple years the message has been the same: Interest rates are at historic lows, and the only place to go is up. With rates near zero, there is no doubt that interest rates will eventually begin to creep up. The realization that interest rates will eventually rise is accompanied by the conventional wisdom that when rates rise, bond prices fall and you should sell your bonds. This basic investing tenet, of course, has many bond investors worked into a frenzy trying to predict when exactly interest rates will rise and when they should pull their money. While this tenet holds true in the short run – a rise in interest rates will lead to a fall in bond prices – the long-term reality of rising interest rates is a bit more intricate.
It is important to remember that the primary driver of bond returns is interest income. While increasing rates work against bonds in the short-term, the ability to gradually re-invest into a rising rate environment actually helps build long-term growth. This increase in income helps offset the initial price decreases, often quite quickly. Over time, the rising income stream should provide a return advantage.
In addition to a more stable income stream, bonds offer lower volatility relative to equities, even in rising rate environments. Two very important characteristics of fixed income are capital preservation and a low correlation with equity markets. Historically, bond declines have been dramatically less severe and faster to recover than stock market declines.
Despite the long-term advantages of rising rates to those who can weather the storm, many investors have fled the bond market for the safety of cash and money market instruments. This inevitably turns out to be a mistake. The small but positive return from money market investments reassures some investors, but this return comes at a higher cost over the long run. Money markets currently pay near zero interest. After inflation, however, the return is negative. This is a high price to pay for capital preservation. Historically, bonds have almost always provided a return greater than cash instruments, and the compounding effect of higher rates over time should work to the long-term investor’s advantage.
Finally, when the financial press harps on rising rates affecting bond prices, the focus tends to be on Treasuries, which are the most sensitive to rising interest rates. The global market for bonds, however, is a vast, complex array of corporate and high yield bonds, mortgage-backed securities, floating rate issues, emerging market bonds, and other fixed income instruments. A skilled bond fund manager can take advantage of the diverse fixed income universe and mitigate the effects of rising rates.
The bottom line, as always, is to stay the course. For long-term investors, rising rates are nothing to fear.