A rate increase will affect fixed income holdings, but should properly-diversified investors react?

Federal_Reserve_ShutterstockLast week according to schedule, the Federal Reserve Bank’s Open Market Committee met and agreed to leave interest rates untouched at 0% – 0.25%, with a hint that they would raise rates by the end of the year. What should investors do about this, especially those with significant fixed income holdings?

I argue that the answer is, “not much.” While it’s true that bond prices move in the opposite direction as rates, different factors affect how much those prices adjust, and the impact on a portfolio can range from “some” to “almost negligible.”

First, why do rates and prices move in the opposite direction? The intuition here is straightforward: if rates rise, bond buyers would rather own new bonds that pay at higher interest rates than old bonds that are paying at lower interest rates. Thus, as interest rates rise, the price of bonds already in the market start to fall.

Conversely, when interest rates fall, bond buyers would rather hold old bonds that are paying higher interest than new bonds that pay lower interest rates. Thus, as interest rates fall, bond prices rise, all else being equal.

Though it is clear which direction bond prices will move as interest rates move, the rate change alone doesn’t speak to how much the prices will move. For this, we look to the “duration” of the bond holdings. Duration, simply, is a measure of the time a bond will pay interest and principal back to its holder.*

Consider how investors might view holding a short versus a long duration bond as rates rise: they’re much less likely to want a low interest paying bond for a long period of time than one where they’ll get their principal back fairly soon. Thus, the longer the duration of the bond, the more the bond’s price will be affected by the rate change. Again, this logic makes sense, all else being equal. As an approximation, a quarter-point increase in rates would produce a decline in the price of a five-year duration bond of about 1.25% (0.25% * 5 = 1.25%).
 

SigFig Asset Management expectations: Short Duration Fixed Income asset classes prices fall a little, but won’t collapse

For SigFig’s Asset Management clients, the duration of the fixed income ETFs is an important consideration. Our current allocations use Short-Term US Treasuries, with duration of approximately 1.8 years, while our broader US bond holdings have an average duration of approximately five years.

The Federal Reserve’s statement indicates that they expect to increase rates slowly, starting sometime before the end of the year, as the US economy continues to improve and settle on firmer footing. The Fed’s meeting notes suggest an expectation of 0.5% – 0.625% by the end of the year. Furthermore, they expect to raise rates very slowly over the next couple years.

Putting this in more concrete terms, if rates increase by one-half percent this year (with all else being equal), we may expect our Short-Term US Treasury and broader US Bond holdings to fall by approximately 1% and 2.5%, respectively.
 

For well-diversified portfolios, holding bonds still makes sense

Within the context of a well-diversified portfolio, it is reasonable to continue holding bonds in the face of a rate increase.

First, the impact to the total portfolio could be relatively small: though a 60/40 stock-bond portfolio might see the individual bond positions lose 1% – 2.5%, the total portfolio’s value could fall by less than 0.75%, even if the equity positions are unchanged.

Second, fixed income assets continue to provide diversification benefits to the equity positions in the portfolio.

Third, a rate increase would be good news, because it signals that the Federal Reserve believes the economy is growing stronger, with increasing evidence that the recovery is sustainable. Moreover, increasing economic stability suggests that borrowers (bond issuers) are more likely to repay their holdings (i.e., they are more creditworthy) and that could actually decrease their borrowing costs.

Finally, potential losses in fixed income are offset by the possibility that US bond values increase because of global macroeconomic instability (e.g., Greece-Eurozone concerns, Russian-Ukrainian war) as investors seek higher quality investments.

SigFig’s Investment team continues to watch the Federal Reserve’s actions with interest. We view that future rate increases signal the Fed’s belief in the growing strength of the US economy, which bodes well for company profits, equity prices, and consumers. In sum, pending rate adjustments do not mean an impending collapse in bond prices; the reality of bond price movements is complex and multi-faceted, and so bonds remain an important piece of a balanced portfolio even in the face of potential interest rate increases.
 

*The duration is typically shorter than the bond’s maturity, because the bond will usually pay interest back to the holder periodically before repaying the principal back at maturity, but since the principal repayment is usually the largest cash flow back to the investor, that last payment is weighted the most heavily.
Aaron Gubin
Aaron Gubin leads research for SigFig’s Wealth Management team. He holds a Ph.D. in Finance and taught investments and portfolio management to graduate and undergraduate students before coming to SigFig. His research focuses on asset allocation, behavioral finance, and investment management.