For the last decade or so, economists and investment advisors have agreed that “interest rates can’t go much lower — they’re bound to rise, and probably soon”. But the rate on the benchmark 10-year US Treasury bond has, over the last ten years, fallen from between 4% and 5% down to around 2%. Since mid-2011, the rate has been fluctuating between 1.5% and 2.5%, more or less (click here for a current chart). This has been great for folks credit-worthy enough to buy a home, as mortgage rates have also been at long-time lows. But it is true that the longer-term average rate for the 10-year Treasury is about 6.5%. So what happens when rates do begin to rise? And what will that mean for the bonds and bond funds in our investment portfolios?
The first thing to know about bond prices and interest rates is that they vary inversely — that is, they move in opposite directions. If interest rates rise, then the price of individual bonds will fall. The second thing to know is that the longer the term of the bond (or, more precisely, the higher its “duration”, measured in years), the more sensitive its price will be to interest rate changes. So here’s a table showing what happens to the value of a bond portfolio, at various combinations of rate increases and portfolio durations.
When we look at the aggregate of all our clients, the average effective duration of our bond portfolios is about 3.7 years. This is intentionally a little shorter, and thus more conservative, than the industry standard, because we’re trying to prevent large impacts on our portfolios. If interest rates were to rise from about 2% to 3% in a very short time, we would expect that our bond portfolios would drop by about 3.7%.
We expect that, over the next few years, interest rates will push back toward the longer-term average — say, to about 6%. We don’t know when that will begin, or how quickly it will happen, though. If it were to begin tomorrow, and move quite quickly, we could see our bond portfolios drop in price by nearly 15%! That would represent a truly huge move, though, and we think it’s highly unlikely to take place over a short period. Far more probable, we think, is that the team at the Federal Reserve, led by Janet Yellen, will continue to keep the brakes on interest rate changes. If they move to raise rates in the slowly-but-surely fashion that they’ve been talking about, then we’d expect to see the rise to 6% over the course of several years. This would give the managers of our bond funds and portfolios a chance to adjust, and earn part of the difference back with the new higher interest payments.
Right now, interest rates are at a low point not seen in decades, and we think it’s bound higher. It’s possible that the benchmark rate could drop further, of course: some European countries and corporations are issuing bonds with negative interest rates. But we think that rising rates are more likely than falling rates, and we’re planning — and investing your bond allocations — accordingly.