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Common investor questions: Rising interest rates

While a significant rise in rates appears unlikely to us over the near-term, many investors have already begun to seek potential portfolio hedges should rates climb. The following questions address some common investor concerns, and some misconceptions, about fixed income investing and rising rates.

Q: When rates go up, do all bonds lose value?

A: Not necessarily. Changes in interest rates don't affect all bonds equally, as bond pricing, like stock pricing, can be complicated and typically reacts to a variety of factors.

According to traditional bond math, the longer a bond's duration*, the more its price may be affected by changing interest rates. Keeping all other factors the same, for example, a bond with a 10-year duration will usually lose more of its price if interest rates go up than would a note with a duration of two years. In addition, the lower a bond's "coupon" rate (that is, the interest rate stated on a bond when it's issued), the more sensitive the bond's price may be is to changes in interest rates.

Duration, bond pricing, and interest rates example

Portfolio duration Change in interest rates
-3% -1% 0% 1% 3%
1 year $103,000 $101,000 $100,000 $99,000 $97,000
2.5 years $107,500 $102,000 $100,000 $97,500 $97,000
4.25 years $112,750 $104,250 $100,000 $95,750 $87,250
5.75 years $117,250 $105,750 $100,000 $94,250 $82,750
7 years $121,000 $107,000 $100,000 $93,000 $79,000
10 years $130,000 $110,000 $100,000 $90,000 $70,000
15 years $145,000 $115,000 $100,000 $85,000 $55,000

Chart data are hypothetical, for illustrative purposes only, and not indicative of any particular investment. Numbers are based on principal investment amounts only and the calculations do not take convexity or certain other factors into consideration. Convexity is a measure of the relationship between bond prices and bond yields.

*Duration is a measure of the sensitivity of the price of a fixed income investment to a change in interest rates. Duration is expressed as a number of years.

The degree to which a bond's price may drop when interest rates rise depends greatly on the bond's duration.* The higher a bond's duration, the more its price could change with a move in interest rates.

It’s important to note, however, that bond pricing is not as simple as the above “rules” would imply. For example, the price of a variable, or floating, rate bond may not be impacted as much by interest rate movements and prices on corporate or structured bonds (such as mortgage backed securities) also may react to a number of different catalysts, of which interest rates are just one. Historically, when interest rates have risen, certain asset classes have lost value. Even in the face of rising rates, though, some fixed income asset classes could continue to generate positive total returns. (Total return encompasses both change in prices and interest rate payments.)

For this reason, some investors turn to diversified portfolios of fixed income assets to help offset the potential effects of rising interest rates.

Q: How might rising interest rates affect my bond fund?

A: It’s possible your fund could lose value in a rising rate environment, but it’s not a certainty. Investors should keep in mind that, as rates rise, the income generated from a bond fund can help offset falling prices, thus potentially cushioning the Fund’s overall total return. The key questions may concern the amount of the drop in a bond’s price and whether there is enough income to offset that decline.

The speed at which rates actually climb is another consideration investors should take into account. If rates rise gradually, the income from a bond fund may be able to offset some of its price decline. Quicker, more dramatic increases over shorter time frames, however, make it challenging for income to compensate for price declines. On the Delaware Investments Fixed Income team, we believe that the U.S. Federal Reserve will take a gradual approach to unwinding its accommodative stance. For this reason, combined with the still-tentative economic path that the U.S. economy remains on, we do not see a rapid rise in rates as a very likely scenario.

Q: What steps could I take to help prepare for rising rates?

A: Investors can take several steps to attemp to help to prepare for rising interest rates, including:

  • Given the potential risks that rising rate environments pose for intermediate (or longer) duration bond portfolios, many bond investors prefer to help limit their exposure to rising interest rates by investing in shorter-duration funds. These funds generally tend to experience smaller price declines as interest rates rise.
  • Consider diversifying your bond portfolio. Look beyond investments in U.S. Treasurys, which are highly sensitive to rising interest rates, and consider turning to segments of the bond market that are generally less interest-rate sensitive. For example:
    • Investment grade and high yield corporate bonds also tend to react to changes in a company’s financial outlook or broad macroeconomic economic conditions, making them potentially less sensitive to rate changes than other asset classes.
    • Floating-rate securities may provide more income than short-term investments and may provide minimum payment amounts (floors) that protect against declining interest rates and liquidity.
    • Foreign bonds (sovereign or corporate) respond, among other factors, to the interest rate cycles of their respective countries, which can diversify a bond portfolio’s allocation and help protect against rising interest rates in the United States.
  • If rates rise as a result of improving economic conditions or an uptick in inflation, you may want to consider alternative sources of bond and non-bond income to help offer inflation protection. Treasury inflation-protected securities (TIPS) are one avenue that some fixed income investors turn to as an inflation hedge under these circumstances.

Q: Might it be a good idea to sell my bonds and invest in stocks or cash instead?

A: Before making any major decisions with your fixed income allocation, it’s important to remember the traditional roles that bonds tend to play in a portfolio — that is, to provide a fixed level of income and to help balance the volatility normally associated with equity investments. These very basic considerations may be lost as investors fret over the potential specter of rising rates.

Risk-adjusted returns: 25-year period
January 1, 1987–December 31, 2012

Rising Rates Q&A

Chart is for illustrative purposes only, and not indicative of any particular investment.

Source: Morningstar, January 2013.

Past performance does not guarantee future results. Data are based on historical returns and standard deviation figures for a portfolio that combines the S&P 500® Index and Barclays U.S. Aggregate Index from Jan. 1, 1987, through Dec. 31, 2012, in various percentages. Not representative of the performance of any specific investment.

Standard deviation is a statistical measure of the dispersion of a set of data from its mean; it is used by investors as a gauge for the amount of expected volatility. • The Barclays U.S. Aggregate Index is a broad composite that tracks the investment grade domestic bond market. • The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the U.S. stock market. Indices are unmanaged. An investor cannot invest in an index.

Due to their limited correlation* to stocks, bonds may add stability to a broader investment portfolio, while potentially improving its risk-return profile.

*Correlation is a statistical measure of the degree to which two securities (or indices) move in relation to each other.

Before selling the fixed income portion of a portfolio, investors should also consider:

  • Interest rate increases in past cycles have generally unfolded gradually — not in quick, large movements. If the next interest rate cycle follows suit, reinvesting maturing bonds into higher yielding options could help offset potential price losses.
  • While it may be tempting to try to time the markets, moving between broad asset classes is very difficult to time correctly. What’s more, adding equities to a portfolio may increase the portfolio’s risk profile, as the above chart indicates, while adding cash investments may weaken a portfolio’s growth potential and lower its yield. We believe investors are better served by adjusting their fixed income allocations and relying on the benefits of diversified, active, and professionally-managed portfolios rather than simply abandoning a major asset class entirely.

Consider Delaware Investments

Whether you are worried about rising interest rates or other potential headwinds to your fixed income portfolio, Delaware Investments offers a wide range of fixed income investment options that may suit your needs.

You may want to look in particular at our multisector funds, each of which provides a risk-conscious approach to investing in the fixed income markets. Each Fund offers an ability to shift its portfolio based on the portfolio managers’ evaluation of economic and market conditions and return expectations for the various sectors within which the funds invest.