On December 14, 2016, the Federal Reserve raised the federal funds rate (the rate at which banks and other financial institutions can lend money overnight) for the second time in the past decade (the first hike was in December 2015). The Fed also signaled it planned for additional hikes throughout 2017. As a result, the prolonged stretch of rock-bottom interest rates appears to finally be coming to an end, and many investors are preparing for what additional rate hikes could mean for their portfolios.
Given the inverse relationship between interest rates and bond prices, many bond investors have long worried they will face negative returns in the near future as rates continue to rise. While factors other than the Fed affect interest rates on bonds across the maturity and credit spectrums, bond investors have been feeling the effects of rising rates recently. For example, as interest rates on 10-year U.S. Treasuries have risen 85 basis points between September 2016 and December 2016, the Barclays U.S Aggregate Bond Index has lost roughly 3%.
However, short-term losses are not always a cause of alarm. For one, if investors consider their bond investments from a total return approach, as interest rates increase, assets can be reinvested at those higher rates, and the higher income earned can negate some of the short-term effects of falling bond prices. For those with long investment horizons, rising rates can be a tailwind.
More so, other segments of the bond market, particularly those used in many multi-asset portfolios such as target date funds, are less sensitive to rising interest rates. High-yield bonds, international bonds, and emerging-markets bonds are examples of bond market segments in which company or country specific dynamics often have a larger effect on future returns than changes in interest rates. In contrast to the investment-grade benchmark, the Barclays High Yield Bond Index returned a positive 1.6% during the last three months of 2016.
Finally, a rise in interest rates is a signal that the Fed believes the economy is in good shape. Within the equity market, while some stocks may drop in the short-term as the cost of borrowing rises and equity investors demand a higher premium for investing in more risky assets, a growing economy would be positive for stock markets.