Josh Barrickman, Vanguard’s head of fixed income indexing for the Americas, points out that it’s not all bad news. “The rise in interest rates has created some short-term pain, but long-term investors are likely to gain from higher-income opportunities.”
Barrickman suggested a helpful rule of thumb: If your time horizon is longer than the duration of a bond fund, then you stand to benefit.
What’s behind the bond market moveA change in political power can bring heightened uncertainty, which markets don’t like. The bond market sell-off is an indication investors are continuing to digest unknowns, which include projections that U.S. economic growth could see a short-term boost under President-elect Trump’s agenda. That said, there are many factors that affect the prospects for growth, well beyond policy proposals.
“The market reaction makes sense if higher inflation is seen in the future. Investors will demand more compensation to lend money in the bond market,” said Barrickman.
Furthermore, markets are responding to increasing expectations that the U.S. Federal Reserve will raise rates in December. It’s a move that would be the second increase since the Global Financial Crisis and would signify an effort to remove accommodative policies put in place after the crisis gradually.
“It’s the change in expectations that moves rates and bond values,” reminded Barrickman. “Higher rates mean a healthy economy and higher-income opportunities, both of which are good for long-term investors.”
Short-term pain, long-term gainBarrickman doesn’t think the recent move in interest rates is a good reason to change your bond allocation. A bond’s total return comes from interest income, price changes, and, for those who reinvest bond income payments, interest earned on interest. In a rising-rate environment, interest can be reinvested at higher coupon rates. This compound interest can be a significant boost for bond fund investors in the long run.
“If you’re systematically investing in a broadly diversified bond fund, stay disciplined and take advantage of higher rates. Don’t be tempted to time the markets. Such bumps in the road are difficult to predict and smooth out over the long run,” he said.
Looking ahead, the Fed has indicated that the pace of future rate increases will be gradual. Vanguard’s economists are anticipating as much, and this is likely to translate into lower bond market volatility and a more benign environment, rather than one in which rates rise sharply. Whether rates are expected to rise or fall, Vanguard recommends that you develop and stick with a steady mix of stocks and bonds that fits your goals and time horizon.
All investing is subject to risk, including the possible loss of the money you invest.
Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.
Diversification does not ensure a profit or protect against a loss.