Bonds: What to Do When Rates Rise

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It seems like a simple strategy when interest rates threaten long-term bonds: bulk up on short-term bonds that won’t be hurt as much.

But it’s not so simple, according to an analysis by The Vanguard Group. Rising rates can hurt short-term bonds more than many investors realize.

“Investors should view the role of bonds in their own portfolios today the same as they did before the crisis and should guard against overreacting to concerns over rising rates,” Vanguard Chief Economist Joseph Davis said in a statement accompanying the report.

Investors have been plowing money into individual bonds, bond funds and exchange-traded funds to escape risks in the stock market and to earn higher yields than they can get in bank savings and money markets. But Vanguard says bonds are best viewed as a long-term bet and a way to diversify a portfolio, or spread risks among various types of assets.

While many investors view bonds as “safe,” bond values tend to fall when interest rates rise, as many experts now expect, because investors would rather have newer bonds with more generous yields. Long-term bonds are hit harder because their owners are stuck with sub-par yields for longer.

That’s why many investors shift toward short-term bonds when rates are expected go up. This is what investors have been doing in recent months, Vanguard says. Pricing in the bond markets suggest that investors expect rates on the 10-year U.S. Treasury bond, a long-term benchmark currently at about 3.6%, to rise to 4.4% in a year, 5.2% in three years and 5.6% in five years, Vanguard says.

But bond trading also shows that investors think short-term rates will rise faster, causing a “flattening of the yield curve,” when the difference between short- and long-term rates will be smaller than it is today. Yield on the two-year Treasury note, for instance, is expected to rise from today’s 0.87% to 5.28% in early 2015. The gap, or “spread,” between two- and 10-year Treasury yields would fall from 275 basis points, or hundredths of a percentage point, to just 32 basis points.

The Federal Reserve will raise short-term rates to keep the economy from overheating, thus reducing the inflation worries that tend to drive up long-term rates. The yield curve flattened in such a way when the Fed raised short-term rates in 2003 and 2004, Vanguard says.

Some experts argue long-term rates will rise because the growing federal debt will force the government to pay more to attract bond buyers. But Vanguard says this has not typically happened, as interest rates are more heavily affected by inflation expectations, which are not closely tied to government debt.

If short-term rates jump, prices of existing short-term bonds could fall, while long-term bond prices would hold up fairly well if long-term rates rose only slightly. This combination could offset any benefit investors could get from shifting money to short-term bonds.

So Vanguard figures long-term investors should stick with the allocations they have rather than shifting to short-term bonds.

“Over the long term, it’s interest income — and the reinvestment of that income — that accounts for the largest portion of total returns for many bond funds,” the Vanguard study concludes. Over the long term, bonds with longer maturities tend to pay considerably more than bonds with short maturities.

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