How Will Rising Rates Affect Bonds?

Since the 2008–09 financial crisis caused bond yields to plunge to new lows, market forecasters have been predicting a rise in interest rates. And when bond investors think rates will increase, they tend to move to short-term bonds or cash. That has certainly been popular advice over the last three-and-a-half years.

As bond investors now know, the forecasters were spectacularly wrong about the direction of interest rates. Yields have fallen since the crisis, and as I wrote about in a recent feature for Canadian MoneySaver, anyone who moved to to short bonds or cash did far worse than investors who simply held the whole bond market. From 2009 through 2011, the iShares DEX Universe Bond (XBB) delivered an annualized return of 6.9%, compared with 4% for the iShares DEX Short Term Bond (XSB), and about 1.5% for cash.

The next three years

The fear of rising yields is even more palpable today, and the soothsayers may be proven right. But how badly would bond index funds suffer in a rising rate environment?

To get some insight, I ran some hypothetical scenarios to see how things might shake down if rates all along the yield curve climbed 100 basis points (1%) annually for the next three years. Then I asked BlackRock, provider of iShares ETFs, to estimate how that might affect XSB and XBB. The numbers in the table below are based on the following assumptions:

• During the entire three-year period, the profile of the two bond indexes—their duration and average maturity, for example—remain approximately the same as they are today.
• Credit spreads—the difference between the yield on government bonds and corporate bonds of the same maturity—remain where they are now.
• The rate increases occurs at the beginning of the year, resulting in an immediate decline in the value of the fund.
• Over the next 12 months, cash flows from coupon payments and the sale of bonds are reinvested at the new higher rates.

What’s the takeaway message from this simulation? The first is that bonds probably didn’t perform as poorly as you expected. With our simulated rate increase of 1% annually across the yield curve, XBB suffered three straight years of negative returns, but the losses were modest. Rising rates will hurt certainly bond returns, but the talk of bonds getting “killed” is probably overstated. Remember, too, that rate increases like this are likely to happen only if the economy gets red hot, which would probably lead to higher equity returns on the other side of your portfolio.

But there’s something else to consider: the opportunity cost you would have paid if you sat in short-term bonds or cash during the last three years, waiting for the rate hikes that were “certain” to come. As my Canadian MoneySaver article explains in detail, if bond returns over the next three years turn out to be similar to those in our simulation, XBB would still outperform both XSB and cash during the full six-year period beginning in 2009.

Investors should accept that no one can predict interest rate movements, and it is expensive to try. Rather than making tactical shifts that amount to guessing, bondholders are likely do best when they choose a diversified fund with an appropriate duration for their time horizon, and then hang on for the long term.