What effect does Fed action have?

When the Fed raises the federal funds rate—as it did most recently in mid-March—yields on bonds of different maturities rise as well, but not always to the same degree.

Roger Aliaga-Diaz
Roger Aliaga-Diaz

Bonds issued with higher yields are more attractive to investors. The demand can drop for existing bonds offering lower yields, and that affects the bonds’ price, as prices and yields move in opposite directions. But depending on the degree to which the rising rates were calculated into current yields, longer-term bonds may react differently to a rate change. This makes it difficult to predict accurately which bonds will be affected most.

“Some short-term volatility in the bond market can be expected at times like these; it doesn’t change our medium- to long-term outlook in the markets,” said Roger Aliaga-Díaz, Vanguard’s chief economist for the Americas. “The fundamentals of our economy have not changed.”

The role bonds play is unchanged

Regardless of reactions to Fed interest rate changes, it still makes sense over the long term to include bonds in your portfolio. Bonds help offset potential downturns in stocks, in part because their prices tend to rise when equity prices fall, but also because of the income they provide through their yields.

In the chart below, you can see how significantly income affected the returns of various Vanguard bond funds over the decade ended December 31, 2016.

Long-term rates for Vanguard bond funds

Granted, Fed rate increases could bring short-term pain to bondholders. But higher rates can benefit long-term bond investors. By reinvesting earned income at higher rates, investors can help offset bond price declines with larger income returns.

It’s best to take a holistic view

Andrew Patterson
Andrew Patterson
Diversifying your investments can help reduce risk, although you can never completely eliminate it. Look at how you divide your investments among stocks, bonds, and cash equivalents, and understand the role each investment plays in your portfolio.

Vanguard senior economist Andrew Patterson noted that Vanguard’s economic and investment outlook remains guarded but not bearish.

“When the Fed raises rates multiple times, that’s a sign of good news in the economy,” he said. “The Fed’s actions are a reflection of conditions more than a driver.”

Notes:

All investing is subject to risk, including the possible loss of the money you invest.

Investments in bonds are subject to interest rate, credit, and inflation risk. Diversification does not ensure a profit or protect against a loss.