Rising Interest Rates - A Death Knell For Bonds?

Posted: Updated:

Guessing the direction interest rates will take is difficult - even for the experts. But our current economic environment indicates interest rates could continue to rise this year. Whether you're a borrower or an investor, you need to understand the financial risks involved.

Thus far in January, the interest rate for a 10-year U.S. Treasury bond has risen about 0.25 percent. As a result, the average bond has lost about 1 percent, according to Barclay's Aggregate Index. That may not sound like much, but losing 1 percent in three weeks is a sizeable move in the typically slow-moving world of bonds.

Why Interest Rates May Continue Rising

The domestic economy is growing at about 3 percent. In addition, there are other signs of improvement. Plus, we have a new tax plan that is likely to accelerate growth, at least in the short-term. As a result, we're seeing growth at or above the long-term average during a time of well-below-average interest rates. Historically, this combination has occurred infrequently.

The global economy is also growing better than expected. Every one of the 45 largest economies is expanding. According to Josh Zumbrin of the Wall Street Journal and the OECD (Organization for Economic Cooperation and Development), this hasn't happened since 2004 - 2007. Clearly, the accommodative stances (e.g. lower interest rates) taken by the world's central banks are no longer as necessary. The U.S. began tightening interest rates in 2016. If they haven't already done so, the world’s central banks will likely follow suit in 2018.

Unemployment is low and presumably can't get much lower. With a strong economy and low unemployment, the pressure to increase wages is bound to intensify. Wage inflation could potentially lead to higher overall inflation. This scenario would encourage the Federal Reserve to raise rates even higher than it had originally planned.

The Fed is already suggesting we'll see three interest rate increases in 2018 to its key rate. Market experts are skeptical that this will actually occur. However, the Fed has the potential to surprise the market. And when it does, rates can move quickly and market values can fluctuate significantly as future expectations adjust to a new norm.

What's The Impact on Long-Term Bonds?

If you're concerned about rising rates, you'll want to avoid long-term bonds such as the German Bund, as well as low-yielding bonds, like U.S. Treasuries or developed countries' sovereign debt. You definitely want to stay clear from 30-year U.S. Treasury bonds! Why? If the interest rate on a 30-year Treasury bond were to rise 1 percent, its value could fall by 20 percent (Market Data Center from The Wall Street Journal). The payout on this bond is only 2.9 percent. It would take a long time to break even after a 20 percent loss!

Which Bonds Hold Their Own?

Short-term maturity bonds are often sheltered from the impact of rising rates. If rates rise, your bond matures soon and you can quickly buy a new bond at a high rate, then you’ll be earning higher yields faster. Floating-rate bonds can also be an attractive investment. Their yields reset periodically to match the movement of underlying rates, such as the prime or the LIBOR (London Interbank Offered Rate).

Which Bonds Might Actually Do Well?

No bond is guaranteed to do well when rates rise. However, it’s possible that foreign bonds may weather an interest rate increase better than domestic bonds. Why? They are affected by currency fluctuations, which can influence returns (for good or bad), and their own domestic interest rate movements. This month can serve as a good example. As U.S. bonds have declined and the dollar has lost value, most foreign bonds have seen gains.

Higher-yielding corporate bonds can benefit from rate increases, if rates are rising due to improving economic conditions. Struggling companies that issue high-yield bonds have an easier road during times of strong economic growth. The loss from rising interest rates can be offset by the presumed increase in security of the issuing corporation. In bond jargon, a BB rated bond that is upgraded to BBB will get a bump in price, all else being equal.

Summary: Advice For Investors And Borrowers

If you're an investor, you need to be comfortable with what you own and the risks you're taking. A diversified portfolio that includes floating-rate bonds and foreign bonds can help alleviate risks associated with rising domestic rates. These investments carry their own unique risks, so be sure to understand those before making changes.

If you're a borrower, take the opposite strategy. Be willing to lock in rates today for longer periods and avoid floating rates tied to the prime or LIBOR. If rates rise, you'll be saving on interest payments for a long time!

Bill Wendling, CFA, is a Senior Portfolio Manager with Bedel Financial Consulting Inc., a wealth management firm located in Indianapolis. For more information, visit their website at bedelfinancial.com or email Bill.

  • Perspectives

    • Job Insights For The Third Quarter

      To provide accurate and timely employment forecasts for business leaders, Express Employment Professionals International Headquarters conducts an ongoing Job Insights survey to track quarterly hiring trends across a wide range of industries. Express surveyed business owners, decision makers, and human resource professionals about the overall hiring trends in their markets and how they impact their hiring decisions. Overall confidence remains high going into the second half of 2018.



Company Name:
Confirm Email:
INside Edge
Morning Briefing
BigWigs & New Gigs
Life Sciences Indiana
Indiana Connections


  • Most Popular Stories

    • Purdue Professor, Wife Indicted For Fraud

      A Purdue University professor and his wife have been indicted on federal fraud charges. U.S. Attorney Thomas Kirsch's office says Qingyou Han and Lu Shao are accused of hatching a scheme to defraud the National Science Foundation. 

    • Walmart Details Crawfordsville Layoffs

      Walmart Inc. (NYSE: WMT) is reducing workforce at the Walmart Optical Lab in Crawfordsville. In a notice to the state, the company said 108 employees will be out of work by the end of September. A corporate spokeswoman told Inside INdiana Business the decision was a response to "changing business needs." She added "we are making adjustments at our Walmart Optical Labs in Crawfordsville to help ensure we have the right people in the right place at the right time."

    • How to Attract and Keep Top Millennial Talent

      At a time when Indiana’s unemployment rate is at its lowest level in more than 14 years, Hoosier companies have to up the ante to attract talent. You want the best, the brightest and most innovative individuals joining your team, and many of these workers are just now entering the workforce.

    • The Impact of Technology on Economic Development Policy

      In a world where technology is enabling almost everything, economic development policy makers are faced with several challenges when planning and implementing strategies for economic growth. Communities, regions and states must be able to adapt programs and initiatives to address the economic disruption caused by technology. In particular, investments in tech and talent are vital to ensuring economic growth and wealth creation for residents and businesses throughout the world.

    • Ivy Tech Predicting Student Performance With Big Data

      The largest post-secondary education system in the state is using big data to try to predict success or failure of students. Ivy Tech Community College Chief Technology Officer Lige Hensley says the school's Project Early Success program has shown 83 percent accuracy in predicting students' 16-week performance three weeks into a term through behavior pattern analysis. Hensley says Ivy Tech is pulling in about 100 million rows of data per day through its efforts.