Bond Interest Rate Sensitivity
Sensitivity of a bond’s price to changes in interest rates depends, to a large extent, on the bond’s duration. The idea is, the longer it takes the bond to mature, the greater the chances of changes to the interest rates. As a rule of thumb, for every percentage point change in interest rates, the bond’s price should ideally move in the opposite direction to the extent of its duration. For example, a one-percentage point increase in interest rates should cause a 10-year bond’s price to drop by 10%. But that’s just theory. The chart below displays the ways in which a 1% interest rate change can affect returns on different types of bond investments.
What Causes Rising Interest Rates?
First, there are many factors that affect interest rates, and many reasons why they might rise. Here are some of the most common factors that can lead to higher rates:
Stronger economic growth Rising inflation Growing notions that the Federal Reserve will raise short-term rates at some point in the future Higher risk appetites, which prompt traders to sell lower risk, fixed-income investments (which drives rates up, and prices down) and buy higher-risk bonds (which drives rates down and prices up).
Which Types of Bonds Can Protect Against Rising Rates?
Here are six other types of bonds to think about when you’re looking to protect your portfolio against rising rates fueled by any of the reasons listed above.
Floating-Rate Bonds
Unlike a basic bond, which pays a fixed rate of interest, a floating-rate bond has a variable rate that resets periodically. The advantage of floating-rate bonds, compared to standard bonds, is that any risk due to changing rates is in large part removed. While an owner of a fixed-rate bond can suffer if the current interest rates rise, floating-rate notes can pay higher yields if existing rates go up. As a result, they tend to perform better than standard bonds when rates are rising.
Short-Term Bonds
Short-term bonds don’t offer the same yields as bonds with longer terms, but they are safer when rates start going up. This does not mean that short-term issues feel no effect from rising rates, but the impact is much more muted than it is with longer-term bonds, for two reasons: 1) the amount of time to mature is short enough that the odds of a major increase in rates during the life of the bond are lower, and 2) bonds with shorter terms are less sensitive to rate changes than longer-term debt.
High-Yield Bonds
High-yield bonds are on the riskier end of the fixed income spectrum, so you might not expect them to perform better than others when rates are rising. The main risk with high yield is not from rate changes but from credit risk, which is the chance that the issuer may default. High-yield bonds, as a group, can in fact hold up well when rates are rising, because they tend to have a lower duration (again, less sensitivity to rate changes) than other types of bonds that mature in nearly the same amount of time. Their yields are often high enough that a change in existing rates doesn’t take as large of a bite out of their yield advantage over Treasuries as it would to a bond with a lower yield. Since credit risk is the main driver of how well a high yield bond performs, the asset class tends to do well when the market improves. This isn’t true for all areas of the bond market since stronger growth often goes hand in hand with higher rates. As a result, a market of faster growth can help high-yield bonds, even as it hurts other parts of the market that are more vulnerable to rate changes.
Emerging Market Bonds
Like high-yield bonds, emerging market issues are more sensitive to credit risk than they are to rate changes. Here, traders tend to look more at the underlying fiscal strength of the country that issues a bond than they do at the current level of rates. As a result, improving global growth can—but not always—be good for emerging or newer markets’ debt, even though it often leads to higher rates in the older markets.
Convertible Bonds
If you own convertible bonds, which are issued by corporations, you know that you have the power to convert them to shares of stock. One side effect of this perk is that it makes them more sensitive to shifts in the stock market than a standard basic bond would be. In other words, there is a greater chance that convertible bonds can rise in prices when the bond market as a whole is under pressure from rising rates.
Inverse Bond Funds
As you invest, don’t forget to access the wide range of tools that can be used to bet against the bond market. ETFs and exchange traded notes (ETNs), for example, move in opposition to the underlying security. In other words, the value of an inverse bond ETF rises when the bond market falls, and vice versa. You also have the option to invest in double-inverse and even triple-inverse bond ETFs. The purpose here is to provide daily moves that are two or three times the changes of their underlying index. While these exchange-traded products provide options for highly savvy traders, most fixed-income investors need to be careful with inverse products. Losses can mount quickly, and they don’t track their underlying indices well over long spans of time. Further, an incorrect bet can offset gains in the rest of your fixed-income portfolio, which can defeat your main goals in the long term. Be aware that these exist, but be sure you know what you’re getting into before you invest.
What Assets Should You Avoid if Rates Rise?
The assets that perform worst when rates are on the rise tend to be longer-term bonds. Treasuries, corporate bonds, and municipal bonds fall into this group. “Bond substitutes,” such as stocks that pay dividends, can also suffer massive losses in a market where rates are on the rise.
The Bottom Line
Timing any market is tricky, and for most people it’s even harder to predict whether interest rates will rise or fall. As a result, as you invest, use the options above as methods for getting the most out of your portfolio diversification. Over time, a well-diversified portfolio can help you raise your odds of outperforming across the full range of interest rate scenarios.
