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What Rising Rates Mean for Your Bonds

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar. What will rising rates mean for bonds and bond funds? That's a burning question for investors today. Here to answer that question for us is Eric Jacobson. He is director of fixed-income research for Morningstar. Eric, thanks for being here.

Eric Jacobson: Glad to be with you, Christine.

Benz: Let's start with a basic, functional question. It's been a while since we've had a sustained period of rising interest rates. Can you discuss, Eric, the mechanics of what happens in a rising rate environment and why that tends to be bad for bonds and bond funds?

Jacobson: Well, let's just start with the fact that when people talk about rising rates, it's important to distinguish between what is affected by the government, which is principally what people refer to as Fed funds--which is the rate that's controlled by the Federal Open Market Committee.

That's something that changes depending on meetings that they have every few months, and it's what's referred to often as a "policy rate." Usually, that's a very short-term rate. Right now, it's targeted between 0 and 25 basis points, or a quarter point. It's very, very low.

When that number changes, it will very likely affect a lot of different rates that are linked to it. Whether it's corporate borrowing, or any number of loans of any kind that might be linked either to Fed funds--or more likely, some other rate that benchmarks off of it or very close to it, like LIBOR--that could really affect borrowing costs for a lot of entities.

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The other issue, of course, is what happens to longer-term rates. While the government can affect those, as they have in the last year to some degree by purchasing securities in the market and so forth, by and large where longer-term rates are is determined a lot by the investment community more widely.

What happens after the Fed next raises short-term rates is a little difficult to say today, because we're probably far enough away from it that we still don't know quite where we'll be in terms of inflation, in terms of what the market expects.

Depending on what that is like at the time, we may see long-term rates move up with short-term rates, or temporarily they may stay relatively flat or fall a little if the market isn't really concerned about inflation.

But by and large--and again, this is not really a prediction but sort of a description of consensus--there's a feeling that not only is the Fed going to raise rates by the end of the year, perhaps, but also that, eventually, market yields across the maturity spectrum will probably come up some over the next year or so.

Benz: That, in turn, depresses bond prices. So let's talk about some of the worst places to be in a rising-rate environment, places where you would see, potentially, real losses.

Jacobson: Well, oddly enough, in cases like this the bonds that have the highest credit quality are typically the most sensitive to changes in Treasury yields. Treasuries, themselves, being the first example.

Then again, even high-quality, investment-grade corporate bonds, for example, if their yields are relatively tight to Treasuries, as we say, they will tend to be very sensitive to price changes. The longer the maturity on that bond, the longer its duration is, the more price sensitivity it's probably going to have.

Benz: So the flip side would be that some lower-quality bonds, while they may have other types of risks, might be less interest rate sensitive.

Jacobson: That's absolutely right. What's important sometimes to understand in scenarios like this is that that depends a lot on the economy as well. If you go back and look for examples, like 1994, when rates spiked up pretty sharply, but at the same time the economy was doing pretty well. So lower-quality bonds benefited from that improving economic picture at the same time that high-quality bonds were being hurt pretty badly because rates were rising.

Benz: Right. In terms of practical advice for bond investors, I've been hearing from a lot of investors who are thinking about getting a little bit fancy with their fixed-income exposure, maybe downplaying intermediate-term bonds, sticking with cash rather than having any fixed-income securities. What's your advice about how to navigate in this kind of environment, where the expectation is that rates will be heading up?

Jacobson: Yeah, I'm not a big fan of the idea of going all the way to cash, because it leaves you out of the market...

Benz: Yields are zip right now.

Jacobson: Right. The dangerous part there, very often, is that people who consider that sometimes say, "Well, I'll just take on a little bit more risk than cash. I'll go into a very short-term bond fund." Which isn't necessarily a bad idea; there are some very good ones.

You want to be really careful not to accidentally get into something that's taking on risks that you don't really see or understand. In that very competitive universe, it's not entirely uncommon for funds to take on credit risk or some sort of structural risk--with mortgages perhaps--that maybe the manager isn't completely going to be in control of if the market goes sideways.

Benz: Right. You're thinking, basically, stick with your plan. Maybe delegate to a manager who has some flexibility to navigate in an uncertain environment?

Jacobson: That's right. Unless you feel you're 100% certain you know what's going to happen--and I think people should be more realistic about it than that, right? That you probably don't want to adjust your asset allocation based on a near-term expectation for the market, but keep it consistent with what your overall personal financial goals are.

If you're taking too much risk in your bond funds to begin with, well, that's a different issue. That's something you may want to look at spreading it around, but I would think of that as more a strategic question.

Benz: OK. Eric, thanks for the practical advice. We appreciate it.

Jacobson: My pleasure.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.