What Happens to Bonds if Interest Rates Rise?

How long can it last? The Federal Reserve has said that it will do what it can to keep interest rates low, but these efforts cannot stem the tide forever; it’s inevitable, at some point, that interest rates will rise and diminish bond prices. The only question is: when and how much?

A fifth year of easing has left some of the decision makers at the Fed thinking it’s time to reverse gears; the minutes of a December meeting cited “several” policymakers wanting to raise interest rates sooner rather than later. Considering how long and open-ended the easing period has been, this caused a slight decline in the stock market.

The Fed’s easing is tied to the unemployment rate. The U.S. has made great strides in improving the economy and helping people find jobs; the December 2012 reckoning has unemployment at 7.8%, down from October, 2009’s high water mark of 10.2%. The official Fed policy is to continue the easing until unemployment reaches a more comfortable 6.5%; this is roughly where we were at in 2008, as the financial crisis emerged. While we’re getting closer to this goal all of the time, 6.5% could take a year or more to reach.

In the short term, meaning the next few months, the bond market climate may not change. The question is: what happens when it does?

Are bond investors going to pay for it? At some point, interest rates will rise again; bond market values will fall. When that happens, how many bond owners are going to hang on to their 10-year or 30-year Treasuries until maturity? Who will want a 1.5% or 2.5% return for a decade? Looking at composite bond rates over at Yahoo’s Bond Center, even longer-term AAA corporate bonds offered a 2.5%-4.15% return in the first part of January.

What do you end up with when you sell a bond before its maturity? The market value; if the federal funds rate rises 3%, a longer-term Treasury might lose as much as a third of its market value as a consequence.

This risk aside, what if you want or need to stay in bonds? One avenue may be to exploit short-term bonds with laddered maturity dates. The trade-off in that move is accepting lower interest rates in exchange for a potentially smaller drop in the market value of these securities if rates rise. If you are after higher rates of return from short-duration bonds, you may have to look to bonds that are investment-grade but without AAA or AA ratings.

If you think interest rates will rise in the near future (to the chagrin of many bond investors), exploiting short maturities could position you to get your principal back in the short term. That could give you cash which you could reinvest in response to climbing interest rates. If you really think bond owners are in for some pain in the coming years, you could limit yourself to small positions in bonds.

Appetite for risk may displace anxiety faster than we think. Why would people put their money into an investment offering a 1.5% return for 10 years? In a word, fear. The fear of volatility and a global downturn is so prevalent this spring that many investors are playing “not to lose.” Should interest rates rise sooner than the conventional wisdom suggests, owners of long-term bonds might find themselves losing out in terms of their portfolio’s potential.