Don't Fear the Rising Interest Rate Environment – Just Roll With It

By Scott Colbert, CFA® Chief Economist, Director of Fixed Income - The Commerce Trust Company

January 24, 2017

Intermediate Bond Portfolio 1- to 10-Year Ladder of Maturities Interest Rate Shocks Total Return Scenarios - 12/31/2016

No Change Gradual: +0.25% per Year Instantaneous: +2.50% in 1st Year
YEAR Annualized Cumulative Annualized Cumulative Annualized Cumulative
1 2.1% 2.1% 1.2% 1.2% -6.8% -6.8%
2 2.1% 4.3% 1.3% 2.7% -1.2% -2.5%
3 2.1% 6.5% 1.5% 4.5% 0.7% -2.0%
4 2.1% 8.7% 1.6% 6.5% 1.6% 6.7%
5 2.1% 11.0% 1.7% 8.9% 2.2% 11.7%
6 2.1% 13.3% 1.8% 11.6% 2.6% 16.8%
7 2.1% 15.7% 2.0% 14.6% 2.9% 22.2%
8 2.1% 18.2% 2.1% 18.1% 3.1% 27.8%
9 2.1% 20.7% 2.2% 21.9% 3.3% 33.7%
10 2.1% 23.2% 2.3% 26.1% 3.4% 39.9%

Source: Barclays Gov/Credit Intermediate Index 12/31/16. Yield: 2.11%, Maturity: 4.39 yrs. In the "No Change" column, the chart shows how maintaining an intermediate bond portfolio for 10 years would perform for the bondholder if interest rates remain unchanged. Note the cumulative return over 10 years reaches 23.2% in year 10. In the "Gradual column, where the Fed slowly raises rates 0.25% per year, the same intermediate bond portfolio reaches a 26.1% cumulative return by year 10. In the last column, the chart shows how an instantaneous 2.50% interest rate spike across all maturities in year 1 hurts investor return dramatically at the outset, but recovers quickly until reaching a 39.9% cumulative return in year 10.

With interest rates as low as they are today, bond fund investors are rightfully worried about what could happen if (or when) interest rates begin to rise.

As most investors know, when interest rates rise, bond prices decline immediately. Less understood, however, is that as interest rates rise, the reinvestment of all other monies compounds at those higher rates, over time offsetting the decline in bond prices.

For an investor in an intermediate bond portfolio, projected cumulative returns are 23.2% over the next 10 years if interest rates remain at today's levels. But if rates begin to rise gradually, cumulative return picks up to 26.1% with no negative annual return.

And, amazingly, if rates spike up immediately, your return increases to 39.9% as higher coupons (periodic interest payments a bondholder receives) offset the initial negative return by year three. Ironically, bond investors should be "rooting and cheering" for higher rates rather than fearing them. This is why we do not encourage investors to abandon the bond market or to move materially short in maturity with their investment allocation.

Takeaways:

  • While a bond's value may temporarily decrease during the rising interest rate environment predicted for 2017 and 2018, funds reinvested in a fixed income security at the higher interest rate generally offset the bond's price decline over time.
  • Bonds often play an important role in a well-diversified portfolio, providing both predictable income and principal protection.
  • Talk to your Commerce financial advisor when considering fixed income investments appropriate for your particular circumstances and portfolio allocation.
Disclosures
  • Past performance is no guarantee of future results, and the opinions and other information in the investment commentary are as of Jan. 24, 2017. This summary is intended to provide general information only and reflects the opinions of The Commerce Trust Company Investment Policy Committee.
  • This material is not a recommendation of any particular security, is not based on any particular financial situation or need, and is not intended to replace the advice of a qualified attorney, tax advisor or investment professional. Diversification does not guarantee a profit or protect against all risk.
  • The information in this commentary should not be construed as an individualized recommendation of any kind. Strategies discussed here in a general manner may not be appropriate for everyone.
  • Commerce Trust does not provide tax advice or legal advice to customers. Consult a tax specialist regarding tax implications related to any product or specific financial situation.
  • Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. All expressions of opinion are subject to change without notice depending upon worldwide market, economic or political conditions.
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