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The Impact of Rising Interest Rates on Bonds

How investors should think about their bond allocations today.

In the following excerpt from her recent webcast, "Your 2022 Midyear Portfolio Checkup," Morningstar director of personal finance and retirement planning Christine Benz discusses:

  • How bonds perform when interest rates rise.
  • How to stress-test your bond funds.
  • What types of bonds investors should own.

Watch the full webcast: "Your 2022 Midyear Portfolio Checkup."

Christine Benz: Now I want to talk about how rising interest rates affect your portfolio and how to think about them going forward. We showed this slide before. Bond yields have risen very quickly in a very short period of time over the past year, and that has driven a lot of the weakness that we've seen, certainly in the bond market, but also in the stock market. Your portfolio, if you have fixed-income assets, has no doubt already felt some of the pain, especially in the fixed-income area. 

How Bonds Perform When Interest Rates Rise

Long-term bonds, we've talked about why they tend to be especially hard-hit in an environment like the current one. They have been hit the hardest. They're down about 20% for the year to date through mid- to late June. Long-term government-bond funds have been particularly hard-hit. And then, intermediate core bonds and what we call core-plus bond funds are down a little bit less but still down double digits for the year to date through mid- to late June. So, you've certainly seen weakness in your portfolio no matter what you have in terms of your fixed-income exposure. Short-term bonds have performed better. We saw on that style box slide, where we looked at bond market performance, their losses are in the realm of 3% or 4% for the year to date.

So, the Fed has done a good job along the way of telegraphing its impending moves of telling us about what it anticipates to do with interest-rate changes, what it's seeing in the economy. And so, I would say that much of what the Fed has said has already been priced in. The issue is that the Fed doesn't know necessarily what's ahead for inflation. It doesn't know whether the interest-rate changes that it has made so far and that it plans to make in the balance of this year, whether they will be sufficient to tamp down inflation. So, that's the risk as investors think about their fixed-income portfolios today, that even though very likely the Fed's near-term movements are priced into bond prices, if there is an unexpected spike in inflation, an unexpected spike in interest rates, we could see further weakness in our bond portfolios.

How to Stress-Test Your Bond Funds

So, I've long enthused about this idea of running your fixed-income holdings through what's called a duration stress test, or what I think about as a duration stress test. And to do this you just need to find two data points for each of your fixed-income holdings, and this will be especially useful for your high-quality fixed-income holdings. So, you're finding your fund's duration, which you'll be able to find on Morningstar.com on the Portfolio tab for a fixed-income fund. Or you can find it on your investment provider's websites. You're finding duration. And you're also finding a number called SEC yield, which is Securities and Exchange Commission yield, and that's a recent snapshot of your fund's yield. So, you're finding those two numbers. You're subtracting the yield from the duration. And the amount that's left over is roughly the amount that you would expect to see that portfolio, that fund, lose in a one-year period in which interest rates rose by 1 percentage point. So, if we saw another 1-percentage-point increase in interest rates, you would likely see price declines at this general level. So, it's just a good ballpark estimate of what to expect if we see further interest-rate increases.

To use a simple example, a long-term government-bond fund today has a very long duration of about 18 years and a yield of 3.0%, 3.5% today. So, what you can see, if you subtract that 3.0% yield, and the concept is that you get to keep your yield regardless of what happens with bond prices--if you subtract that 3.0%, 3.5% yield from that 18-year duration, that's a roughly 15% loss in that one-year period where we would see a rate increase by 1 percentage point. If you look at intermediate-term funds, which is what most of us own as our core fixed-income exposure, you see durations of about 6.0 years today. You see SEC yields in the neighborhood of 3.0% or even higher today. So, you can see with those core type funds they're actually going to be much less responsive in a negative way to interest-rate hikes, to further interest-rate hikes.

What Types of Bonds Should Investors Own?

I like the idea of thinking about your fixed-income portfolio, deciding how much to allocate to short-term bonds, intermediate-term bonds, even cash by thinking about your time horizon, your anticipated spending horizon for your money. So, for your very near-term outlays, if you're retired and you have expenditures for the next couple of years that you'll be withdrawing from your portfolio, my bias would be just to keep that money in cash, not take any interest-rate-related risk. You may see its value get eaten up a little bit by inflation, but I think that generally speaking, you'd rather be safe than sorry with that portion of the portfolio. And then, if you have funds that you expect to spend in the next two to five years, say, there you might hold short-term bonds, which will have much less interest-rate sensitivity. They're not guaranteed in the same way that your cash holdings are. They will have a little bit of interest-rate-related volatility, but they'll be much more stable than intermediate-term bonds.

And finally, I'd think about holding intermediate-term bonds for a time horizon of say five to 10 years. So, if I anticipate spending in five years or beyond that, there I think, I can hold intermediate-term bonds with some confidence that over my particular time horizon until I need my money that my bonds will likely be in positive territory over that five-year period. Whether they will be in positive territory on a real or inflation-adjusted basis is another matter, but just from the standpoint of keeping principal stable, I think that that's a good way to think about segmenting your bond portfolio. Whether you hold long-term bonds in your portfolio as a matter of personal preference, I think that for many investors they're simply too volatile and too equitylike in terms of their behavior.