How changing interest rates affect fixed income

By Dan Bortolotti on May 20, 2015
Estimated reading time: 5 minutes

Get out of the interest rate guessing game to truly understand the risks of various fixed income investments and pick the best ones for you

A 3% decline over several months is modest—it’s a bad day for stocks—but bond investors have been so accustomed to steady gains in recent years that it’s caused a lot of anxiety. More worrisome, it’s revealed that many investors have some fundamental misunderstandings about the relationship between bonds and interest rates, which admittedly can be confusing. Inaccurate information leads to poor investment decisions.

If the last five years have taught us anything it’s that forecasting the direction of interest rates is futile, and countless armchair economists have paid the price for trying to do so. A better approach is to get out of the guessing business and simply understand the risks of various fixed income investments. Then you can make a rational decision about which ones are appropriate in your situation.

It’s also key to appreciate that short-term and long-term risks may differ: avoiding the possibility of loss in the short-term, for example, often comes with the risk of lower long-term returns. That’s why investors with a long time horizon can safely ignore the “guru” on BNN who only cares about his quarterly results and not your retirement plan.

The following table should help you understand the effect of changing interest rates on different types of fixed income investments, in both the short term and the long term. Since you can’t know where rates are headed in the future, the best you can do is understand what to expect from your fixed home holdings under both scenarios.

If interest rates fall

If interest rates rise

Short-term bond fund

Short term: The price of your holding will rise. If the fund has a duration of 3, it would rise in price by about 0.3% if short-term interest rates decrease by 0.1% (10 basis points).

Longer term: With rates on newly issued bonds now lower, reinvested interest and proceeds from maturing bonds will quicklyhave lower expected returns going forward.

Short term: The price of your holding will fall. If the fund has a duration of 3, it would fall in price by about 0.3% if short-term rates increase by 0.1% (10 basis points).

Longer term: With rates on newly issued bonds now higher, reinvested interest and proceeds from maturing bonds will quickly benefit higher expected returns going forward.

Broad-based bond fund

Short term: The price of your holding will rise, and more sharply than short-term bonds. If the fund has a duration of 8, it would rise in price by about 0.8% if interest rates decrease by 0.1% (10 basis points) across the board. The fund will be sensitive to changes in 5-, 10- and 20-year bond yields as well as short-term rates.

Longer term: With rates on newly issued bonds now lower, reinvested interest and proceeds from maturing bonds will graduallyhave lower expected returns going forward.

Short term: The price of your holding will fall, and more sharply than short-term bonds. If the fund has a duration of 8, it would fall in price by about 0.8% if interest rates increase by 0.1% (10 basis points) across the board. The fund will be sensitive to changes in 5-, 10- and 20-year bond yields as well as short-term rates.

Longer term: With rates on newly issued bonds now higher, interest and proceeds from maturing bonds willgradually benefit from higher expected returns going forward.

Five-year GIC ladder

Short term: Unlike with bonds, you’ll see no increase in the value of your GICs. However, you can take comfort knowing that your GICs have rates higher than those currently offered.

Longer term: As each rung of the GIC ladder matures, you will need to reinvest the proceeds at lower rates. The overall yield on your ladder will therefore gradually decrease.

Short term: Unlike with bonds, you’ll see no decrease in the value of your GICs. However, you’ll have some opportunity cost, as your GICs will be locked in for up to five years at rates lower than those currently offered.

Longer term: As each rung of the ladder matures, you will be able to reinvest the proceeds at higher rates rate. The overall yield on your ladder will therefore gradually increase.

Cash

Short term: Unlike with bonds, you’ll see no increase to the value of your cash account. Banks may lower the rates on savings accounts almost immediately.

Longer term: Cash is almost guaranteed to lose to inflation, and you will likely pay a high opportunity cost by avoiding bonds. If you were sitting in cash waiting to get back into the bond market, it backfired: the cost of doing so will be higher and expected returns lower.

Short term: Unlike with bonds, you’ll see no decrease to the value of your cash account. Banks may raise the rates on savings accounts.

Longer term: Cash is almost guaranteed to lose to inflation, and you will likely pay a high opportunity cost by avoiding bonds. However, if you were sitting in cash waiting to get back into the bond market, you got lucky: the cost of doing so will be lower and expected returns higher.

This article originally appeared on Canadian Couch Potato