How Do Rising Interest Rates Impact Bond Investments?

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Last week the Federal Reserve announced the first of seven anticipated interest rate hikes this year to try to tame high inflation. Will inflation remain high, and if so for how long? How high will interest rates go?

Holding on as rates go up

Over the past 40 plus years, inflation has been tame. Interest rates have decreased in a nearly linear fashion.

High inflation and a period of sustained rising interest rates is a possibility. If it happens, it will be something few of us have experienced in our investing lifetimes.

It is worth taking time to understand fundamentals of what happens to bond investments under these conditions. How would it impact your portfolio and retirement spending needs? How can you prepare yourself?

The Roles of Bonds In Investment Portfolios

The first thing to consider when determining how rising interest rates will impact your portfolio is to determine why you are holding bonds. Bonds traditionally play three roles in an investment portfolio. Bonds:

  1. Provide fixed income payments.
  2. Often have low, or even negative, correlation to stocks creating diversification benefits.
  3. Provide stability in times of economic uncertainty.

Related: Retiring With Extreme Low Interest Rates

The Role of Your Financial Position

The other thing we need to consider is your current financial position. Are you in accumulation mode or decumulation mode? 

If you’re in decumulation mode, what is your burn rate? Are you completely reliant on your portfolio for income, or can you generate income from other sources? Do you have flexibility in your spending, or are most of your expenses fixed?

I’ll discuss the impact of rising interest rates on bond income, bond’s correlation with stocks, and the impact of bond price stability from the perspective of those in accumulation and decumulation mode. 

Bond Income When Interest Rates Rise

Bonds are often referred to as fixed income investments. That’s because the interest rate, or coupon rate, on a newly issued bond is fixed over the duration of the bond.

If you purchase a new 10 year $1,000 bond with a 2% interest rate, you will receive $20 of interest income every year for ten years (assuming no defaults). If rates on similar newly issued bonds drop to 0% or increase to 4%, it makes no difference with regards to the income you will receive over the remainder of the ten years of your bond, assuming you don’t sell it and the issuer doesn’t default.

At the end of the tenth year, you will receive your final interest payment and the return of your $1,000 investment, which you can reinvest in a new bond that will produce income at the new prevailing interest rate. When rates are going up, those new bonds will create more income than the old lower yielding bonds.

Accumulators

If you are in accumulation mode, rising interest rates are a good thing as it relates to your bond investments. If rates jump from 2% to 4%, your new $1,000 bond investment will now produce $40 of annual income rather than the $20 of income a bond yielding 2% would produce. In this scenario, you are essentially buying twice the amount of income for the same price.

Once your old bonds mature you can also reinvest the proceeds into higher yielding new bonds, assuming interest rates continue upward. Your interest payments can be reinvested in new higher yielding bonds as well.

On paper, the bonds already in your portfolio will have a lower market value. But if you don’t have to sell them prior to maturity, the market value is meaningless.

Spending Only Fixed Income In Retirement

A retiree in decumulation mode with a low enough burn rate that they spend only the fixed income interest payments are in a similar situation to the accumulator.

They would continue to receive the income they expected over the life of their bonds. When the bonds mature, the principal can be reinvested at the new higher rates.

However, they wouldn’t benefit as much as the accumulator. They wouldn’t have new money to buy more bonds at higher interest rates. Current interest payments would be spent to support retirement income needs, so they would not be available for reinvestment at the new higher rates.

Still they would benefit over time as older lower yielding bonds are flushed out of their portfolio and replaced with newer bonds that produce more income.

Selling Bonds to Create Retirement Income

Unfortunately, with rates so low, few retirees can live only off of fixed income payments. So they need to sell some of their bonds prior to maturity to create income.

When rates increase, existing bond values decrease. If an old bond yields 2%, and a new bond, all else equal, yields 4%, no one would want the older bond with the lower yield. So you would have to sell it at a discount if you needed to create income.

Once you sell your bond, the principal is forever gone. You don’t get the benefit of reinvesting it back into higher yielding bonds. This is more painful when you have to sell more bonds at a discount to create the retirement income you need because rates on new bonds are higher. When rates are going up to fight high inflation, you may need to sell even more bonds to meet increasing income demands.

For decumulators who rely on selling bonds to create retirement income, rising interest rates are painful.

The Correlation of Stocks and Bonds When Interest Rates Rise

Correlation is the relationship between two variables. Positive correlation means both variables move in the same direction. Negative correlation means that two variables move in opposite directions. Uncorrelated variables have little or no relationship to one another.

Because economic cycles are cyclical, we ideally want to have negatively correlated assets in our portfolio. Thus when one is down, the other is up. This way we always have something that is performing well. Stocks and bonds frequently function in this manner.

“Normal” Relationship Between Interest Rates and Economic Cycles

When the economy slows down, interest rates are often cut. This makes borrowing less expensive which promotes more economic activity.

When the economy gets overheated, inflation can result. Interest rates are often increased. Higher interest rates make borrowing more expensive, which tends to cool off the economy and slow inflation.

This cycle often results in bond and stock prices moving out of sync with one another– i.e. they  have low or negative correlation. This frequently provides a diversification benefit between stocks and bonds.

Retirees can sell the asset that is up in value, while the asset that is down has time to recover. Accumulators can rebalance their portfolio by selling off a portion of the asset that is doing well, to buy more of the asset that is down and thus has more room to grow. However, this is not a perfect relationship

Related: Is It Time to Rebalance Your Portfolio?

Cutting rates juices the economy, which is nearly always politically popular. Raising rates voluntarily inflicts economic pain. Even if it is a short-term solution to prevent bigger future problems, it is rarely politically popular. So interest rates have gradually drifted downwards over the past four decades. 

Current Relationship Between Interest Rates and the Economic Cycle

We currently face a unique set of economic circumstances. Inflation is accelerating quickly. Interest rates are being raised in an attempt to prevent inflation from getting completely out of control.

Simultaneously, the stock market and the economy more generally are showing signs of weakness due to a combination of geopolitical and pandemic related factors. Domestic stocks are also starting with very high valuations, which tends to correlate with lower future returns.

Related: Retiring With High Market Valuations and Low Interest Rates

Higher interest rates may further slow the economy. Ben Carlson recently summed up the complicated historic relationship between rising interest rates and stock market performance.

Raising interest rates may help create a perfect storm for diversification benefits between stocks and bonds to fail us when we need them most.

Bond Prices When Interest Rates Rise

The third role bonds traditionally play is providing stability to a portfolio. High quality bonds of short duration never made anyone rich. Traditionally, they did give you a safe place to park your money to keep up with inflation.

With yields so low, this has been challenging recently even with low inflation. Now that inflation has spiked ahead of interest rates increasing, it is certainly not true.

Vanguard’s Short-Term Bond Index Fund (VBIRX) is an example of a fund of high-quality investment grade bonds of short duration. The average duration of bonds in the portfolio is 2.7 years. 

It would normally be considered a very safe place to hold your money with regards to price fluctuation. This fund would also be a reasonable place to get a little extra yield over savings accounts. 

One year nominal returns for that fund as of 2/28/2022 are -2.27%. The combined impact of the negative nominal return and high inflation over the past year means that money in this typically very safe short-term bond fund has lost about 10% of the purchasing power it had just a year ago in real (inflation-adjusted) terms!

Take Home Messages

As I work through what rising interest rates and high inflation mean for bonds specifically and investment portfolios more generally, I don’t see any easy answers. I do have a couple of key take home messages.

Understanding the Impacts of Inflation

We focus on market returns, volatility, and sequence of returns in retirement planning discussions. Until the past year, inflation has received much less attention. We may have been lulled into complacency by decades of consistently low inflation.

Stock prices and interest rates are cyclical. When asset prices fluctuate, if you can avoid selling assets at decreased prices they tend to recover and become more valuable over time.

Inflation rates are cyclical as well. There is a key difference that makes periods of high inflation far more punishing to investors and more difficult to plan for. 

The impacts of inflation decreasing purchasing power of your dollars are mostly permanent. Since the 1940’s, we’ve had only three years where the CPI was negative. Only one of those, -.09% in 2015, occurred in the past 66 years.

Once inflation occurs, prices that have increased don’t tend to come back down. The rate of inflation may slow, but prices continue adjusting upward from ever higher levels. Your dollars consistently become less valuable over time.

Fixed income investments and cash tend to be hurt the worst by inflation. This is true even in the best case scenarios. Periods of high inflation just make these impacts more obvious.

Redefining “Conservative” Investing

Traditionally being an aggressive investor meant that you held more risky assets with returns that traditionally were higher — i.e. a higher allocation to stocks. Traditionally being a conservative investor meant that you held less volatile assets with returns that were traditionally lower — i.e. a higher allocation to bonds.

Over short periods of time, this is a reasonable way to look at risk. Over longer periods of time, bonds become riskier. This is especially true in periods of high inflation and rising interest rates that we are now seeing.

Is high inflation a short term outcome of a unique set of circumstances related to the pandemic and the response to it, further compounded by recent geopolitical events? Maybe.

Will long term demographic trends and technological advances make a return to low inflation rates and relatively small increases in interest rates a reality? It’s certainly possible.

Are we in store for a decade of rising interest rates and high inflation similar to the 1970’s? Could high inflation and rising rates contribute to a “lost decade” for stocks similar to the 2000’s? Could both occur simultaneously? Any of those are possibilities as well.

Preparing for Challenging Times

To be prepared for any scenario, we need to reconsider what it means to be conservative in our planning. That goes well beyond how much of your portfolio you allocate towards stocks and bonds.

The best signs of preparing conservatively are having a plan that does OK under any circumstances. Beyond portfolio construction, there are four key elements to being fiscally conservative entering retirement:

  • A low initial burn (withdrawal) rate that gives margin for error and limits eroding investment principal
  • Flexibility in spending
  • Ability to earn additional income in retirement
  • Diversification beyond traditional stock and bond investments.

Having all four elements could be prudent planning, particularly for early retirees. Lacking any would require more margin with the others to be truly conservative in your planning for those entering retirement in an already challenging economic environment of high stock valuations and low interest rates. 

That environment may be getting more challenging if inflation and rising interest rates persist.

Related: Pulling Your Retirement Levers

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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. After achieving financial independence, Chris began writing about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. Chris also does financial planning with individuals and couples at Abundo Wealth, a low-cost, advice-only financial planning firm with the mission of making quality financial advice available to populations for whom it was previously inaccessible. Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He has spoken at events including the Bogleheads and the American Institute of Certified Public Accountants annual conferences. Blog inquiries can be sent to chris@caniretireyet.com. Financial planning inquiries can be sent to chris@abundowealth.com]

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17 Comments

  1. Thanks for this very timely article. I don’t know what the answer to the current economic conditions are. I agree if you are younger and still in the accumulation stage you can and should just ride it out and rebalance to an asset allocation that you can sleep with. On the other hand if you are close to or in retirement it gets a little more complex. This is the situation I find myself in. I looked over some investing advice by the big guns, like Warren Buffett and John Bogle. Buffett is not an admirer of bonds his instruction for his wife’s investment account is simple 90% index 500 and 10% short term government bonds naturally this is a bit of a moot point as I am certain she will have more in this investment account than she will ever be able to spend unlike most of us, but it’s interesting all the same. John Bogle is another story but even at a older age he had far more in stocks than bonds I believe he had close to 80% in stocks and really didn’t rebalance his account’s much. I have also looked at Morningstar advice for diversification and they came to the conclusion that some of the better known diversification measures were not that effective such as gold, and REITS. They also seemed to like short term government bond in regard to a negative correlation to stocks. The problem there is the yield is not enough for most people to live off. Perhaps Buffett is right stick with stocks and to a lesser extent short term government bonds? Someone else suggested this approach but substituted a high yield dividend stock fund for the index 500. I’m trying to figure this out for myself. Not easy!

    1. Mark,

      I think studying people like Buffett is interesting, but we need to be very slow to apply anything they do to our situation because our situations are so different. (I’m assuming you’re not a multibillionaire with a frugal lifestyle 😉 ).

      The Morningstar conclusion is interesting, particularly with regards to gold. I’ve come to a different conclusion based on backtested modeling, leading me to add a small amount of gold to my portfolio. https://www.caniretireyet.com/going-for-gold/ It seems to be doing what I had hoped so far, providing positive returns when traditional assets all are not. Will that continue? Time will tell????

      One thing we can certainly agree on is that investing, particularly under current conditions is not easy!

      Best,
      Chris

      1. Hi Chris,
        Thanks for the follow up. I didn’t mean to make it sound like I was going all in on Buffetts advice for his wife’s portfolio, I am frugal but certainly not as wealth as the Buffetts. I have made some changes to my portfolio but nothing drastic.I’m more of a buy and hold investor, I did do a little rebalancing as my stock and bond allocation is getting out of whack. I do find it interesting how these guys think about investing, both Buffett and Bogle saw no need to invest in international funds either bond or stock. That seems to go against conventional wisdom. Recently I was reading about Harry Brownes Permanent Portfolio which advocates 25% stock, 25% long term Treasures, 25% gold and 25% cash, that’s an interesting idea too, but I don’t think I will invest that way either. I guess the bottom line is you have to do what makes the most sense to you and your needs as well as your comfort level.

  2. As a retired conservative investor I have had significantly higher percentage in bond funds than in equity. Sleeping at night and preservation of assets has been a key priority. I am not taking Social Security until 70, and keep a nice cash cushion. I try to always sell when stocks are high, and only sell low when I want to make a conversion. I keep track of expenses, and keep investment costs low. Now, with bond funds actually going down significantly (relative term) per share price, I am debating taking a loss on some of these bond funds and setting up a bond ladder where my returns will be low but no per share hemorrhaging. I may increase my equity allocation, but only if decline in equity prices. I remember stagflation, and also multiple market drops of high teens for equities. I don’t make big moves generally. I have no debt, and house paid for. Happy for good health, but economic dynamics at present give some pause to the least worse move, if any, to make.

    1. Jon,

      I think the ideas of considering what is “the least worse move” and moving slowly before making any moves with your portfolio are both healthy and wise approaches. As I noted in the post, when diversification of assets in your portfolio fail you, it may be moves outside of the portfolio (having a conservative burn rate, cutting spending, doing something to earn a little income, etc) that will be more impactful and likely to be successful.

      Best wishes,
      Chris

      1. Chris, thankfully if both stocks and bonds go down in value my bucket strategy is such that I have several years of cash so I basically make it unlikely I would need to sell assets that have declined in value. I replenish my cash bucket with assets that have increased in value, while monitoring my asset allocation.

        I admit the free fall in my bond funds, which I have a significant stake in, have me wondering, what if, in this case, sell some of my bond funds and set up a ladder of actual bonds. The ladder would not risk NAV declines. But there would be a one time “hit”…Basically, keeping a portion of bonds in funds, but also keep a ladder system in place as well moving forward. Note-I do not need to sell my bond funds for cash. It is more a shock absorber. (These are tax deferred accounts)

        Are bond ladders a wise compliment to have to bond funds? Your thoughts?

        1. Jon,

          This is a hard question to answer in a blog format as I can’t provide any specific financial advice. I will say that if it were my own money, I would question how much time, effort, and cost would be involved in building a bond ladder on my own or paying someone to help me, how much diversification I would sacrifice (depending on how much money I could allocate to the bond ladder), how much potential benefit I would get for all my efforts and whether the juice is worth the squeeze.

          Best,
          Chris

          1. Chris, your comment “juice may not be worth the squeeze” is excellent point. Part of my interest in this might be an example of frequency bias on my part. Thanks.

  3. The timing on this article was interestingly coincidental, Chris, since we’re in the process of selling a rental property. For the reasons you outlined in your post, I’m struggling with how we’ll deploy the proceeds from the sale. I won’t go so far as to say that I lie awake at night thinking about the lack of safe and viable options, but I will say that I’ve devoted an awful lot of time to considering the possibilities. I haven’t yet found a solution with which I feel entirely comfortable. In the past, I would have just parked the funds in cash or bonds until I figured it out; now, that almost feels like throwing dollar bills in the campfire. I have to say you did a great job of capturing the angst and putting it in print.

    1. Mary,

      It is a challenge. Unfortunately, staying in cash is always a guaranteed loser to inflation. We just keep following our investment policy statement that was designed to work in all circumstances and working on finding solutions outside of our portfolio.

      Best wishes,
      Chris

  4. I agree that this is a time to look at the least worst scenario. Some things we are doing: we were FI last year but have continued to work, after some initial pain we took a capital loss on our biggest bond fund and will look to rebuy later this summer, and have built up more cash looking to redeploy into growth stocks opportunistically.

    I don’t like holding cash, however a more conservative equity allocation is warranted in my view. I think if you’re so inclined, real estate might be a place to go. Being a landlord is not for me unfortunately, but we do benefit at least on paper for what is a crazy market in our area (Bay Area).

    Perspective I think may also help. It’s been a great run. Time to accept that can’t continue for ever and enjoy the fruits. I think this whole situation rolls over in the next year, we have a mild recession, and are back at it in late 2023.

  5. I personally think the idea that keeping some cash is bad because “it’s a guaranteed loser to inflation” is ridiculous. So let’s say you’re invested in the SPY and AGG for a typical 60/40 mix. Your down about 5.5% YTD (although it would have been twice that if for not the furious rally in the last couple weeks). Tell me how that is better than having 25-50% cash? On the inflation point, if 5-10% inflation is going to really affect your lifestyle, well maybe then that tells you to keep working and investing for longer. For example, if you spend $40,000 per year and now it will be $44,000, is that really such a big deal? The answer depends on your personal situation.

    Having cash allows you to take advantage of opportunities, so if the S&P goes down 30% you can purchase shares at a much better valuation than today. Also, with rising yields on everything from CDs to Treasuries to corporates to municipals to preferreds you now have a wonderful opportunity to finally get some yield on your cash. It’s been a tough slog for years for income investors but maybe we will finally have a chance to invest for yield without having to take on equity type risk. The obvious caveat is that rates could go up way further than expected, so ;keeping duration on the short side is the best strategy.

    1. Roberto,

      Cash tends to looks good when the market is going down. Even with current high inflation, at least your money is holding its nominal value while bonds are losing nominal value as rates rise and real purchasing power due to inflation. The same double whammy is happening to stocks.

      But when markets are going up, cash doesn’t look so good. You make very little in interest in this environment while inflation erodes cash’s purchasing power year after year. Best to have a set investment policy that does OK in all environments. “Having cash ….to take advantage of opportunities….” = market timing. It sounds good in theory, but it rarely works out well for investors in reality.

      Regarding 10% inflation not being a big deal, again I disagree strongly. Remember that we don’t just get a 10% increase this year. Even if inflation cools to 2% next year, it is now a 2% adjustment upward from a level that was 10% higher than it was just a year ago.

      I agree that if inflation was only for a year, it shouldn’t kill you. But it never is. Prices don’t come back down systemically. Rates of inflation just tend to slow. And if prices do drop across the board, that is deflation which is even worse. If you don’t understand that concept, do some reading on the great depression.

      Best,
      Chris

      1. Well the reality is that people adjust their spending to compensate for inflation. So while the inflation rate may be 8% or 10% it is highly individualized as to what a given person experiences or controls. For example, if you are a truck driver your costs have increased 30% or more. Maybe you can pass that along to your customers. But if you are a remote worker the large increase in the price of gas (which is a huge component in the current inflation) really doesn’t hurt you.

        So you all think that having cash is a risk, but you don’t see the elephant in the room. The equity markets have had a historic run for 13-14 years. It’s grossly overvalued. Everyone is now a believer in stocks. People buy meme stocks and crypto and the S&P 500 and have done exceedingly well. It’s been easy. But what happens when the music stops? It will be epic and maybe that day will never come. But I’d much rather have some cash on the sidelines than be 60% or 70% in equities. We’ve seen too many market debacles in the last 40 years and I personally don’t want to go through another one.

        1. You’re not saying anything that is not true regarding stock values. The problem is, you could have written that same sentence virtually any day of the past 10 years. It would have been equally true. It would have justified sitting in cash. You would have missed out on massive market increases.

          That is not to say the market won’t crash. It is to reiterate what I stated in my prior response. Timing WHEN it will crash is incredibly difficult. And to get market timing right, you have to also get it right on the downside.

          I agree that you need to know your personal risk tolerance and whether you are willing (and able) to sit through a major market downturn and/or prolonged bear market. I disagree that a timing strategy, as you alluded to in your earlier comment is wise.

          I also agree that your personal inflation rate is more important than CPI. Darrow has written about that on this site. But current inflation is hitting food, energy, transportation, etc. How much it is impact each individual will vary, but almost everyone is being impacted in some way.

          Best,
          Chris

  6. I’m also in the super-long term time horizon club with you and as a whole bonds always feel like they are a net loser when looking really far out but there is one amazing thing about owning them that I do quite love.

    Having something to re-allocate from during a crash. Even more than any actual financial benefit, having a good financial move available to you when the sky is falling feels very empowering at a bad time 🙂

    Love the article!

Comments are closed.