Rising Rates and Bond Investing

You may have noticed that interest rates have recently begun to rise.  According to FreddieMac.com, the average rate for a 30-Yr fixed mortgage has jumped from about 3.5% in May to over 4% in June.  Whether the trend will continue is anybody’s guess, but it is important to consider the impact rising interest rates have on fixed-income investments. 

First, when interest rates rise, bond prices fall (conversely, when rates fall, bond prices rise).  This is easy enough to understand: No one would pay the same price for a bond yielding 1% when new bonds are being issued at 3%. 

Second, even though bonds in general are hurt by rising rates, short-term instruments suffer less than long-term ones.  This is because you get your money back sooner to reinvest into the higher rates. 

Now assume that you invest equal amounts into 5 bonds that mature in each of the next 5 years.  In one year, one-fifth of your portfolio will come due and can be reinvested into a new 5-Yr bond.  This “laddering” strategy is an effective way to continually inject higher-yields into a fixed-income portfolio to mitigate falling prices as rates increase. 

The Vanguard Short-Term Treasury fund (which we widely use in our portfolios) invests primarily in US Treasury Bonds with maturities between 1 and 5 years.  Its relatively short average maturity of about 2.5 years means that the price decline over the past couple of months has been slight.  And the income that the fund generates should start to pick up over time as it buys higher-yielding Treasuries.  We believe that investors with at least a two-year horizon should see minimal negative impact on their total return with the fund, even as rates rise. 

As we manage portfolio withdrawals for our retired clients, we tend to keep the first couple of years of cash-flow in money market funds and CDs.  In our opinion, this should provide enough time for Vanguard Short-Term Treasury’s recovery, should rising rates persist.

Aaron Pettersen CFA, CFP®