How to Think About Increasing Interest Rates

May 2, 2018

Interest rates have gone up relatively significantly this year. Figure 1 shows the increases in the one-, three-, five- and 10-year Treasury bond rates through April 18.

Rising Rates.png

While interest rates moves of these sizes have occurred a multitude of times in the history of the U.S. and global bond markets, they are large enough to catch the attention of some investors. I’ll try to provide some context to the recent increases by examining a couple of questions.

Do Portfolio Adjustments Make Sense?

Let’s start with the easier question. Assuming you own a bond fund or a portfolio of individual bonds of high quality with a relatively short maturity, it’s likely no adjustment is needed. If you don’t, you should think about improving the quality of your fixed income portfolio and potentially reducing the maturity profile. Irrespective of this year’s interest rate moves, there’s minimal historical evidence that shows that lower-quality bonds or longer-maturity nominal bonds improve portfolio efficiency.

Periods like the start of 2018 can make it seem appealing to try and tactically time interest rate moves based on a belief that they will continue to go up. All the evidence we have suggests that, while there may be mild momentum in financial markets, investors are likely better off avoiding market timing in all its forms. On top of this, for investors with high-quality bond and bond fund portfolios, the impact of interest rate risk tends to be negligible relative to stock market risk (and also helps diversify stock market risk). This year provides a great example in that most high-quality strategies with relatively short maturities are down around 1.5 percent or less. No one likes losses, but these are relatively modest compared with the impact stock market declines can have.

What Do 2018 Interest Rate Movements Mean?

While particularly sharp increases in interest rates are rarely good news for markets (and as mentioned above, extremely difficult to predict), more modest increases are usually good news for long-term investors since it means expected long-run returns are higher. This year provides a great example.

At the beginning of the year, the yield on five-year inflation-protected Treasury bonds (TIPS) was about 0.35 percent.1 This means that an investor who purchased this bond could expect to earn 0.35 percent plus inflation over its five-year life. This rate is now up to about 0.70 percent, meaning investors can expect a higher return net of inflation compared with the beginning of the year. While investors in this bond at the beginning of the year will have a loss, if this level of increase holds over the longer term, they will likely earn higher long-term returns. This is just another way of saying that if you are going to be lending money over an extremely long period of time (i.e., some investors might be investing in fixed income for 40-plus years), it’s better to lend at higher rates than lower rates.

1Source: U.S. Treasury
Jared Kizer, CFA, Chief Investment Officer Copyright © 2018, The BAM ALLIANCE. This document and all attachments are provided to you, our client, as a service of BAM Advisor Services, LLC. We hope you will use it to keep abreast of emerging research and investment trends, take advantage of up-to-date advice, and revisit the principles on which your investment advisory practice has been founded. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.