Thursday, February 25, 2010

The Impact Of Rising Interest Rates On Stocks And Bonds

One thing that seems almost certain is the next move in interest rates will be a move higher. What will a move higher in interest rates mean for stock and bond investors?

It should be noted longer term market rates have already been trending higher over the past twelve months. The 30-year U.S. Treasury rate has increased from around 3.5% a year ago to 4.6% today. Short term rates, i.e., the 1-month Treasury rate, has actually declined from around .20% a year ago to .08% today. In other words the yield curve has steepened. But back to the original question.

For a bond investor, higher interest rates will have a negative impact on the price of a bond or price of a bond mutual fund. The impact of this "interest rate risk" depends on the maturity or duration of a particular bond. In its simplest form, the duration indicates how much the price of a bond or price of a bond mutual fund will change given a 1% or 100 basis point change in interest rates. For example, if the duration of the bonds in a bond mutual fund is 5 years, then the price (NAV) of the bond fund will decline 5% (increase) for a 100 basis point increase (decrease) in interest rates. The question for investors then is how long does it take to recover the loss in principal.

In a recent research article from Charles Schwab (SCHW) titled, Should You Worry About Bond Funds if Interest Rates Rise?, it is noted that,
"More than 90% of the total return since 1976 generated from a broadly balanced portfolio of US investment-grade Treasury, agency and corporate bonds has come from interest payments as opposed to change in price..."
If an investor understands the recovery time, they will then know if their time horizon matches the term or duration of the bonds or bond fund.

For stocks they tend to perform better in declining interest rate environments as well. Unlike bonds though, on average, stocks have generated positive returns in rising interest rate environments as well as in declining rate environments. Although stock returns have tended to be positive in periods where interest rates have increased, the better returns are found in declining interest rate periods.

In Standard & Poor's article, Rising Rates Revisited, they include returns be S&P 500 sector as well.

For investors then, if one believes interest rates will trend higher over a period of time in which it will be necessary to access the principal invested, paying attention to the duration of an investment as well as the types of stocks within a portfolio will be important.


Should You Worry About Bond Funds if Interest Rates Rise?
Charles Schwab & Co.
By: Rob Williams
February 24, 2010

Rising Rates Revisited
Standard & Poor's
By: Sam Stovall
February 19, 2010

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