The Federal Reserve raised interest rates in 2022 at a pace not seen since the early 1980’s, leading to one of the worst years for bond investors in history. Rising interest rates have a significant impact on a fixed income portfolio: as interest rates increase, bond prices typically decrease.

As interest rates increase, bond prices typically decrease

Simply described, when interest rates rise new bonds are issued with higher yields, making existing bonds with lower yields less attractive to investors. As a result, the existing bonds will be priced at a lower level to compensate the buyer for the lower yields.

As interest rates rise, bond yields rise too

It is also important to remember the positive impacts of rising interest rates for fixed income portfolios. As interest rates rise, bond yields increase, providing a higher level of income for the bondholder. Higher interest rates provide investors with an opportunity to purchase long duration bonds to lock in a higher yield.

Not all bonds are impacted the same

It is important to note that not all fixed income securities are equally affected by rising interest rates. Longer-term bonds are more sensitive to changes in interest rates than shorter-term bonds. Longer-term bonds will typically decline much more than short-term bonds when interest rates of all maturities are rising. Intuitively, longer-term bonds take longer to mature, creating an opportunity cost by missing the chance to reinvest at higher interest rates compared to short-term bonds that will mature sooner. The opposite is true when rates are falling. Investors will want to lock-in higher coupon payments for a longer time when rates are high and expected to decline in the future.

With all bonds, investors should understand the trade off between interest rate and credit risk. Relatively safe bonds like US Treasuries face more risk from rising interest rates but it is highly unlikely that the US government would ever default on their financial obligations. On the other hand, the return on corporate bonds is more dependent on the underlying creditworthiness of the issuing company.

3 ideas for bond investors 

To help protect fixed income portfolios against the negative impact of rising interest rates, investors have a few options. Investors can:

• Consider purchasing floating rate securities, such as floating rate bonds and bank loans, which provide a hedge against rising interest rates as their coupon payments adjust with changes in interest rates.

• Buy individual bonds and hold them to maturity, eliminating the market volatility associated with the day-to-day value of the bond. However, this will require more due diligence and monitoring than buying a bond fund.

• Consider laddering their individual bond or bond fund portfolio, which involves investing in bonds with a range of maturities. This strategy can help mitigate the impact of rising interest rates, as the bonds in the portfolio will mature at different times, providing more flexibility to reinvest proceeds from maturing bonds at higher rates.

Rising interest rates can have a significant positive and negative impact on a fixed income portfolio. However, by considering a range of strategies, such as investing in short-term and floating rate securities, laddering a bond portfolio, and holding bonds to maturity, investors can help mitigate the impact of rising interest rates and potentially even benefit from them over a full economic cycle. Please consult your financial advisor to ensure what investment strategy is best for you.