In two recent blogs by my colleague, Mike Peters, he first addresses the concerns investors have about rising interest rates causing a bear market in bonds and then lays out what to expect for bond market returns looking forward the next couple of years. In the second blog, he mentions that interest rates higher than the 1-3% range we’ve had over the last five years might actually be a good thing for bond investors.
Since that statement seems counterintuitive, I think it’s worth explaining.
When interest rates rise, the price of your bond goes down. That’s obviously not a good thing at the time it happens, but investors should consider how their bond investment does over time. The change in price is not the only component of your return. In fact, the income you receive and the rate at which you reinvest that income are typically the biggest components of bond returns. Rising rates aren’t the worst thing for bond investors. In fact, for long term investors, rising rates are a good thing. The more rates go up, the more you earn.
The quoted yield on a bond when you buy it assumes the bond is held to maturity and that coupon income is reinvested at the current yield level. If interest rates rise, the coupon income can be reinvested at higher rates, so the realized yield over the holding period will actually increase as rates rise. If you can look past the short term, you will see that rising rates lead to rising total returns over time as you earn more by reinvesting the cash flow from your bonds at higher rates. This fact is often left out of the conversation when talking about owning bonds through periods of rising rates.
Getting your principal back at maturity is only a part of the cash flows you receive over the life of a bond. On a long term bond, for example, the interest you receive and the subsequent interest you get on reinvestment of that interest are the largest parts. If you’ve ever had a home mortgage, you may have noticed the amount of interest you pay on your mortgage over the life of the loan adds up to more than the principal you borrowed! The same is true in the bond example shown in the chart. First, look at the shaded area of the chart which shows we invested $100,000 in a 4% coupon bond with 30 years to maturity. Over the life of this bond, you will receive $120,000 in interest and get your $100,000 in principal back, but the most interesting part is if you reinvest the interest payments at the same 4% rate, you make an additional $108,103. If we look to the right or left of the shaded column, we see how the reinvestment of income changes if rates rise to 6% or fall to 2%. Reinvesting the income at the higher 6% rate versus the lower 2% rate has a huge impact on the total cash you have at the end of the period. In the 6% rate scenario, income reinvestment is responsible for 48% of the total cash you have at the end of the period, while in the 2% scenario reinvestment of income is less, but still 16% of the total. Reinvestment of income over time is an important component of total return and rising rates provide greater earnings power for the reinvestment of that income, which is particularly important for long term investors.
In an environment where you think rates may go higher, changing to a strategy that provides higher cash flows allows you to reinvest more quickly and earn more “interest on interest” to offset the negative effect rising rates has on the price of your bonds. If you are just choosing between two bonds that have the same yield, you should prefer to pay a higher price for a bond with a higher coupon over paying par or a price of $100 for a bond with a lower coupon. That may sound odd, but remember, you will be better off if you receive more cash flow from your coupon payments to reinvest as rates are rising.
Wendy W. Stojadinovic is Director of Fixed Income Strategy