How Do Rising Interest Rates Impact Bond Investments?

Last week the Federal Reserve announced the first of seven anticipated interest rate hikes this year to try to tame high inflation. Will inflation remain high, and if so for how long? How high will interest rates go?

Over the past 40 plus years, inflation has been tame. Interest rates have decreased in a nearly linear fashion. High inflation and a period of sustained rising interest rates is a possibility.

If it happens, it will be something few of us have experienced in our investing lifetimes. It is worth taking time to understand fundamentals of what happens to bond investments under these conditions. 

How would it impact your portfolio and retirement spending needs? How can you prepare yourself?

The Roles of Bonds In Investment Portfolios

The first thing to consider when determining how rising interest rates will impact your portfolio is to determine why you are holding bonds. Bonds traditionally play three roles in an investment portfolio. Bonds:

1. Provide fixed income payments.
2. Often have low, or even negative, correlation to stocks creating diversification benefits.
3. Provide stability in times of economic uncertainty.

Related: Retiring With Extreme Low Interest Rates

The Role of Your Financial Position

The other thing we need to consider is your current financial position. Are you in accumulation mode or decumulation mode? 

If you’re in decumulation mode, what is your burn rate? Are you completely reliant on your portfolio for income, or can you generate income from other sources? Do you have flexibility in your spending, or are most of your expenses fixed?

I’ll discuss the impact of rising interest rates on bond income, bond’s correlation with stocks, and the impact of bond price stability from the perspective of those in accumulation and decumulation mode. 

Bond Income When Interest Rates Rise

Bonds are often referred to as fixed income investments. That’s because the interest rate, or coupon rate, on a newly issued bond is fixed over the duration of the bond.

If you purchase a new 10 year $1,000 bond with a 2% interest rate, you will receive $20 of interest income every year for ten years (assuming no defaults). If rates on similar newly issued bonds drop to 0% or increase to 4%, it makes no difference with regards to the income you will receive over the remainder of the ten years of your bond, assuming you don’t sell it and the issuer doesn’t default.

At the end of the tenth year, you will receive your final interest payment and the return of your $1,000 investment, which you can reinvest in a new bond that will produce income at the new prevailing interest rate. When rates are going up, those new bonds will create more income than the old lower yielding bonds.

Accumulators

If you are in accumulation mode, rising interest rates are a good thing as it relates to your bond investments. If rates jump from 2% to 4%, your new $1,000 bond investment will now produce $40 of annual income rather than the $20 of income a bond yielding 2% would produce. In this scenario, you are essentially buying twice the amount of income for the same price.

Once your old bonds mature you can also reinvest the proceeds into higher yielding new bonds, assuming interest rates continue upward. Your interest payments can be reinvested in new higher yielding bonds as well.

On paper, the bonds already in your portfolio will have a lower market value. But if you don’t have to sell them prior to maturity, the market value is meaningless.

Spending Only Fixed Income In Retirement

A retiree in decumulation mode with a low enough burn rate that they spend only the fixed income interest payments are in a similar situation to the accumulator.

They would continue to receive the income they expected over the life of their bonds. When the bonds mature, the principal can be reinvested at the new higher rates.

However, they wouldn’t benefit as much as the accumulator. They wouldn’t have new money to buy more bonds at higher interest rates. Current interest payments would be spent to support retirement income needs, so they would not be available for reinvestment at the new higher rates.

Still they would benefit over time as older lower yielding bonds are flushed out of their portfolio and replaced with newer bonds that produce more income.

Selling Bonds to Create Retirement Income

Unfortunately, with rates so low, few retirees can live only off of fixed income payments. So they need to sell some of their bonds prior to maturity to create income.

When rates increase, existing bond values decrease. If an old bond yields 2%, and a new bond, all else equal, yields 4%, no one would want the older bond with the lower yield. So you would have to sell it at a discount if you needed to create income.

Once you sell your bond, the principal is forever gone. You don’t get the benefit of reinvesting it back into higher yielding bonds. This is more painful when you have to sell more bonds at a discount to create the retirement income you need because rates on new bonds are higher. When rates are going up to fight high inflation, you may need to sell even more bonds to meet increasing income demands.

For decumulators who rely on selling bonds to create retirement income, rising interest rates are painful.

The Correlation of Stocks and Bonds When Interest Rates Rise

Correlation is the relationship between two variables. Positive correlation means both variables move in the same direction. Negative correlation means that two variables move in opposite directions. Uncorrelated variables have little or no relationship to one another.

Because economic cycles are cyclical, we ideally want to have negatively correlated assets in our portfolio. Thus when one is down, the other is up. This way we always have something that is performing well. Stocks and bonds frequently function in this manner.

“Normal” Relationship Between Interest Rates and Economic Cycles

When the economy slows down, interest rates are often cut. This makes borrowing less expensive which promotes more economic activity.

When the economy gets overheated, inflation can result. Interest rates are often increased. Higher interest rates make borrowing more expensive, which tends to cool off the economy and slow inflation.

This cycle often results in bond and stock prices moving out of sync with one another– i.e. they  have low or negative correlation. This frequently provides a diversification benefit between stocks and bonds.

Retirees can sell the asset that is up in value, while the asset that is down has time to recover. Accumulators can rebalance their portfolio by selling off a portion of the asset that is doing well, to buy more of the asset that is down and thus has more room to grow. However, this is not a perfect relationship. 

Related: Is It Time to Rebalance Your Portfolio?

Cutting rates juices the economy, which is nearly always politically popular. Raising rates voluntarily inflicts economic pain. Even if it is a short-term solution to prevent bigger future problems, it is rarely politically popular. So interest rates have gradually drifted downwards over the past four decades. 

Current Relationship Between Interest Rates and the Economic Cycle

We currently face a unique set of economic circumstances. Inflation is accelerating quickly. Interest rates are being raised in an attempt to prevent inflation from getting completely out of control.

Simultaneously, the stock market and the economy more generally are showing signs of weakness due to a combination of geopolitical and pandemic related factors. Domestic stocks are also starting with very high valuations, which tends to correlate with lower future returns.

Related: Retiring With High Market Valuations and Low Interest Rates

Higher interest rates may further slow the economy. Ben Carlson recently summed up the complicated historic relationship between rising interest rates and stock market performance.

Raising interest rates may help create a perfect storm for diversification benefits between stocks and bonds to fail us when we need them most.

Bond Prices When Interest Rates Rise

The third role bonds traditionally play is providing stability to a portfolio. High quality bonds of short duration never made anyone rich. Traditionally, they did give you a safe place to park your money to keep up with inflation.

With yields so low, this has been challenging recently even with low inflation. Now that inflation has spiked ahead of interest rates increasing, it is certainly not true.

Vanguard’s Short-Term Bond Index Fund (VBIRX) is an example of a fund of high-quality investment grade bonds of short duration. The average duration of bonds in the portfolio is 2.7 years. 

It would normally be considered a very safe place to hold your money with regards to price fluctuation. This fund would also be a reasonable place to get a little extra yield over savings accounts. 

One year nominal returns for that fund as of 2/28/2022 are -2.27%. The combined impact of the negative nominal return and high inflation over the past year means that money in this typically very safe short-term bond fund has lost about 10% of the purchasing power it had just a year ago in real (inflation-adjusted) terms!

Take Home Messages

As I work through what rising interest rates and high inflation mean for bonds specifically and investment portfolios more generally, I don’t see any easy answers. I do have a couple of key take home messages.

Understanding the Impacts of Inflation

We focus on market returns, volatility, and sequence of returns in retirement planning discussions. Until the past year, inflation has received much less attention. We may have been lulled into complacency by decades of consistently low inflation.

Stock prices and interest rates are cyclical. When asset prices fluctuate, if you can avoid selling assets at decreased prices they tend to recover and become more valuable over time.

Inflation rates are cyclical as well. There is a key difference that makes periods of high inflation far more punishing to investors and more difficult to plan for. 

The impacts of inflation decreasing purchasing power of your dollars are mostly permanent. Since the 1940’s, we’ve had only three years where the CPI was negative. Only one of those, -.09% in 2015, occurred in the past 66 years.

Once inflation occurs, prices that have increased don’t tend to come back down. The rate of inflation may slow, but prices continue adjusting upward from ever higher levels. Your dollars consistently become less valuable over time.

Fixed income investments and cash tend to be hurt the worst by inflation. This is true even in the best case scenarios. Periods of high inflation just make these impacts more obvious.

Redefining “Conservative” Investing

Traditionally being an aggressive investor meant that you held more risky assets with returns that traditionally were higher — i.e. a higher allocation to stocks. Traditionally being a conservative investor meant that you held less volatile assets with returns that were traditionally lower — i.e. a higher allocation to bonds.

Over short periods of time, this is a reasonable way to look at risk. Over longer periods of time, bonds become riskier. This is especially true in periods of high inflation and rising interest rates that we are now seeing.

Is high inflation a short term outcome of a unique set of circumstances related to the pandemic and the response to it, further compounded by recent geopolitical events? Maybe.

Will long term demographic trends and technological advances make a return to low inflation rates and relatively small increases in interest rates a reality? It’s certainly possible.

Are we in store for a decade of rising interest rates and high inflation similar to the 1970’s? Could high inflation and rising rates contribute to a “lost decade” for stocks similar to the 2000’s? Could both occur simultaneously? Any of those are possibilities as well.

Preparing for Challenging Times

To be prepared for any scenario, we need to reconsider what it means to be conservative in our planning. That goes well beyond how much of your portfolio you allocate towards stocks and bonds.

The best signs of preparing conservatively are having a plan that does OK under any circumstances. Beyond portfolio construction, there are four key elements to being fiscally conservative entering retirement:

• A low initial burn (withdrawal) rate that gives margin for error and limits eroding investment principal
• Flexibility in spending
• Ability to earn additional income in retirement
• Diversification beyond traditional stock and bond investments.

Having all four elements could be prudent planning, particularly for early retirees. Lacking any would require more margin with the others to be truly conservative in your planning for those entering retirement in an already challenging economic environment of high stock valuations and low interest rates. 

That environment may be getting more challenging if inflation and rising interest rates persist.

Related: Pulling Your Retirement Levers

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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. Now he draws on his experience to write about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. You can reach him at chris@caniretireyet.com.]

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