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Understanding Bonds in a Rising Interest Rate Environment

October 03 2022

Including bonds in your clients’ investment mix makes sense even when interest rates may be rising. Share the resource below with your clients so that they understand what’s happening in the bond market.

If history is a guide, there maybe a hiccup in the bond market over the short term during a rising rate environment, but longer term, it means higher coupon payments bolstering total returns over time.

— Judith Ward, CFP®

A bond fund’s total return is determined by both coupon payments and the bond’s price fluctuation. The graph below illustrates the components of bond returns since 1993. The orange line represents the total return of the U.S. bond market. As you can see, while the price return fluctuates from year to year, the coupon component has always been positive and relatively stable, helping to support total returns.

Understanding Total Returns of the U.S. Bond Market

As of June 30, 2022

understanding total returns of the U.S. bond market

*Includes prepayment factor on securitized products.

The highlighted years are periods of rising U.S. federal funds rate, representing the most recent cycles in which the Federal Reserve increased interest rates over a complete cycle. The year 2013 is circled above for the so-called taper tantrum in which the 10-year U.S. Treasury yield increased by approximately 150 basis points after the Federal Reserve mentioned the possibility of gradually reducing the quantitative easing purchase program.

Source: Bloomberg Index Services Ltd. See Important Information. The U.S. fixed income market is represented by the Bloomberg U.S. Aggregate Bond Index.

When interest rates rise

When the U.S. Federal Reserve raises short-term interest rates, it’s referred to as “Fed tightening.” Technically, the Fed is targeting short-term overnight interest rates. Longer-term interest rates, such as home mortgage rates or 10-year U.S. Treasury yields, are usually driven by investors’ expectations for economic growth and inflation. The highlighted years on the graph above indicate the years when short-term interest rates were increased. While there were periods of price declines and negative total return, these periods were short and were followed by positive returns. Past performance cannot guarantee future results.

Why do bond prices decline when interest rates rise?

If you hold a bond to maturity, the issuer pays interest, also known as a coupon, periodically and returns the principal on the maturity date. Let’s assume the coupon rate of a bond is 5%. When interest rates rise, new bonds will be issued with a higher coupon rate, which means the investor will receive higher payments. That means the old bond with the 5% coupon rate isn’t as desirable. For that bond to be attractive to investors, it must be priced at a discount to the new higher-rate bonds. Bond mutual funds are subject to the same fluctuations.

Rising rates can have a silver lining for bond investors

When the Fed raises short-term interest rates in a measured way (Fed tightening), this can be good news for long-term investors exposed to bonds.

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Bonds remain a critical component of a diversified portfolio as they help dampen the volatility of stock exposure.

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During periods of rising interest rates, regular coupon payments and reinvestment in new higher-yielding bonds help cushion the impact of declining prices for existing bonds and can boost total return over time.

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During past periods of Fed tightening, total returns for bonds (as measured by the Bloomberg U.S. Aggregate Bond Index) were typically benign and eventually recovered.

For additional resources such as how to help your clients understand the role of fixed income, keep a long-term perspective, and chart a steady course, visit Speaking of Markets.

Important Information:

Fixed income securities are subject to credit risk, liquidity risk, call risk, and interest rate risk. As interest rates rise, bond prices generally fall. Index performance is for illustrative purposes only and is not indicative of any specific investment. Its performance does not reflect the expenses associated with the active management of an actual portfolio. It is not possible to invest directly in an index.

Additional Disclosures:

“Bloomberg®” and Bloomberg Indices are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the index (collectively, “Bloomberg”) and have been licensed for use for certain purposes by T. Rowe Price. Bloomberg is not affiliated with T. Rowe Price, and Bloomberg does not approve, endorse, review, or recommend this product. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to this product.

This material being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial, and tax advice before making any investment decision. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness.

© 2022 T. Rowe Price. All Rights Reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc. T. Rowe Price Investment Services, Inc.

202209-2413491

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