Will Rising Rates Really Clobber Bonds?

The concern is certainly warranted. Remember that bond prices and interest rates are on opposite ends of a seesaw: whenever one goes up, the other goes down. But before you make drastic changes to the fixed-income side of your portfolio, make sure you understand the subtleties of interest rates and their effect on bond prices.

Overnight sensation

When people talk about interest rates, they’re usually vague about which ones. The media tend to focus on the overnight rate, which is set by the Bank of Canada in an effort to control inflation.

That rate was 0.25% in April 2009, and in 2010 it ticked upward three times to 1%, where it stands now. If you follow the mortgage markets, you saw that the banks’ prime rates (currently 3%) went up immediately following each of these three hikes in the overnight rate. That’s why variable mortgages and lines of credit got more expensive last year.

However, you may also have noticed that fixed-rate mortgages got cheaper in 2010. That’s because fixed-rate mortgages, which usually have a term of five years, are tied to the yield on five-year government bonds, not the overnight rate. And during 2010, five-year bond yields declined slightly. They fell further this past May, prompting the banks to lower fixed mortgage rates again.

Whenever there’s talk of rising interest rates, someone points out that long-term bonds are the most vulnerable. This is true, but again, it depends which rates you’re talking about. While short-term rates went up three times in 2010, the yield on 10-year bonds fell. As a result, the iShares DEX Long Term Bond Index Fund (XLB) returned a whopping 12.1% last year. The broad-based iShares DEX Universe Bond Index Fund (XBB) earned well over 6.4%, its best showing since 2004.

The lesson here is that the different parts of the yield curve do not move in lockstep, and various lending markets can behave differently over any given period. If you believe the Bank of Canada is going to raise short-term rates in the near future, then you should be worried about your variable-rate mortgage. But if you’re a long-term investor, you shouldn’t be dumping your bond index funds.

Rising rates aren’t new

Investors have faced similar scenarios before. In May 2004, Americans were filled with fear about rising rates. Typical of the media reports at the time, Kiplinger’s Personal Finance magazine warned investors to “Protect your bonds from the coming storm” as the Federal Reserve raised rates to tame inflation. Some pundits were even recommending inverse bond funds, which go up when bond prices go down.

It turns out that the forecasters were absolutely right about the central bank’s actions: Alan Greenspan hiked short-term rates 16 consecutive times until the they reached 5.25% in July 2006. So did bond investors get slaughtered? Not at all: bond prices fell modestly, but the declines were more than offset by the interest payments. The total return on the Vanguard Total Bond Market Index Fund was about 3.5% annually from 2004 through 2006. Long-term bonds—which the magazine specifically warned against—did even better.

It’s happened in Canada, too. From 1987 to the middle of 1990, Canadians watched short-term rates soar from 7.7% to over 14% in 41 months. But the yields on five- and 10-year bonds crept up more modestly during this period, with several dips along the way. As a result, the overall bond market returned almost 4% a year from 1987 through 1990 after inflation.

There’s no arguing that bonds could see trouble ahead, but the dangers are often overstated, or at least misunderstood.