by Donald Gould
Since December, long-term interest rates in the United States have risen steadily, the result of a strong economy and monetary tightening by the Federal Reserve to fight inflation. As a result, bond prices fell in the first quarter of 2022. Rising market interest rates drive bond prices down, to keep their yields competitive with new, higher-yielding bonds.
Aside from falling bond prices, rising interest rates are a silver lining for most bond investors. If rates remain high relative to past levels, the principal of maturing bonds will be reinvested at higher rates, locking in higher interest payments during the term of the replacement bonds. If your investment horizon exceeds the average maturity of your bond portfolio, higher interest rates are good news in the longer term.
Here is an analogy. Suppose you take a road trip from Claremont, California to Claremont, New Hampshire. You calculate that you will need six full tanks of gas to get there. You visit the gas station and fill up your tank at a cost of $100. By the time you’re about to leave on a trip, the price of gas drops by half.
There are two ways of looking at this development. First, you might be heartbroken knowing that you could have saved $50 if you had waited a little longer to get that first tank of gas. True, but the best news is that if gas stays at its new lower price, your next five tanks of gas will cost $250, not $500. You always come out far ahead.
Think of your current bond portfolio as your first tank of gas. Yes, higher interest rates have diminished the value of what you hold today, just as your first tank of gas was devalued when gas prices fell. But the replacement bonds you buy (as the existing bonds mature and interest is reinvested) will pay a higher interest rate. The accompanying chart shows how a 2% rise in market interest rates reduces the immediate value of the bond portfolio, but leads to a significantly higher value over time.
Continuing the metaphor, distance traveled is like your time horizon. Since the distance traveled is many times longer than the distance you can travel on your first tank of gas, lower gas prices are a net benefit to you. Similarly, if your time horizon is longer than the average maturity of your current bond portfolio, you stand out — if you repeatedly “replenish” your portfolio with higher-yielding bonds.
Don Gould is President and Chief Investment Officer of Gould Asset Management of Claremont.