Interest Rates Up, Bond Prices Down. Is There a Silver Lining?

After a long period of falling rates, it looks like we’re about to see a reverse in this trend—at least for long-term rates. What’s driving the change and what could it mean for investors with exposure to bonds?

The push for an increase in rates

While the Reserve Bank’s Official Cash Rate looks likely to stay at its current level until well into 2022, rising economic growth rates and the prospect of inflation picking up means long-term rates could continue to rise.

How do rising interest rates affect bond prices?

The simple answer is it depends.

Typically, when interest rates rise, the market value of bonds falls. Conversely, when interest rates fall, the market value of bonds rises. But bonds have different sensitivities to rates and while it’s true that rate rises can have a negative effect on bond prices, this depends on whether the bond has a fixed rate or a floating rate, and the maturity of the bond (i.e. how long you need to hold the bond for).

Generally speaking, fixed rate and longer maturity bonds are more sensitive to rate rises. That being said, longer maturity fixed rate bonds pay a higher yield than the cash rate, so avoiding owning longer maturity bonds for long periods can negatively impact returns more than the protection you get from being in short-term bonds.

Bonds are not the same as equities, so price declines are limited because eventually the bond issuer must pay back the principal when the bond matures. This means you know what the market value of the bond will be at maturity. So long as you don’t sell, losses from rate movements over time tend to recover as you get closer to maturity.

Why it pays to invest with an active bond fund manager

Rising interest rates can be a good news/bad news story for investors. In the short term, rising interest rates cause bond prices to move lower. However, bonds generate a cash flow (the coupon payments), and these payments can be reinvested at higher levels.

According to Fergus McDonald, Head of Bonds & Currency at Nikko Asset Management, “an active bond fund manager can take advantage of interest rate movements. For example, they can move into longer dated maturities as rates rise and lock in rates at improved levels. If you’ve invested in a bond fund, this means your potential losses are reduced and your potential gains enhanced.

What’s more, if the unit price in the bond fund or a bond price moves lower due to rising interest rates, it is highly likely that future periods will experience a higher level of returns because at maturity, a bond will pay the holder the face value of the bond plus the coupon payments. Unless the issuer defaults (which is rare) you will always get your money back in full plus interest (the coupon payments).”

When considering investing into conservative funds it is worth remembering that most of these funds are heavily invested in bond and cash type assets. Like bond funds, unit prices of conservative funds will swing about with the movement of interest rates. But they have the added diversification benefits of investing up to 30% in domestic and global equities and listed property assets. These types of assets will often perform well when interest rate markets are not, especially if interest rates are rising due to an improvement in the economic environment and growth prospects are looking good.

Remember, it’s time in the market, not timing the market

Trying to pick the timing of a rate change is incredibly difficult (even for professionals). While rising interest rates do present challenges, they are not without some reward. With the return outlook for most asset classes being modest and volatile, you may wish to consider lengthening the time period you hold your investment for and try to look through the month-to-month ups and downs in unit prices. By doing so, you should ultimately be rewarded.

And finally, it is important to remember that long-term interest rates and bond prices have already priced in much of this bounce back in activity since the low point in long term rates in September 2020. That means the impact of rising rates should be dampened as future rises in short term rates have largely been factored in already.