- Your return on a bond is not just about its price. Rising yields can create capital losses in the short term, but can set the stage for higher future returns.
- When interest rates are rising, you can purchase new bonds at higher yields.
- Over time the portfolio earns more income than it would have if interest rates had remained lower.
Bonds play an important role in the investing world. They bring income, stability and diversification to your portfolio. Yet bond investors often worry about rising yields (the total income a bond pays each year). Why? To answer this question, let’s dig deeper into how bond yields work.
What is a yield? It’s the total annual income you earn from bond coupon payments. It’s stated as a percentage of the price of the bond. For example, if you have a $1,000 bond that pays $50 per year, the yield is 5%.
A bond’s yield is influenced by the current market climate, meaning how much investors can demand for lending money to an issuer for a specified period of time. The yield of a bond is also based on the price paid for the bond, its coupon and its term-to-maturity.
Rising interest rates affect bond prices because they often raise yields. In turn, rising yields can trigger a short-term drop in the value of your existing bonds. That’s because investors will want to buy the bonds that offer a higher yield. As demand drops for the bonds with lower yields, the value of those bonds will likely drop too.
However, this near-term view overlooks the longer-term payback of higher yields. Capital losses in the short term can set the stage for higher future returns.
How does duration fit in? Another term often used in discussions about bonds is duration, a measurement of how sensitive bonds are to changes in interest rates. It is expressed as a number of years. Typically, the further away a bond is from its maturity date, the longer its duration and the greater the price change could be when yields move.
An example: how bond portfolios work in different interest rate environments
Let’s assume we have a laddered bond portfolio that is structured as follows:
- We have five bonds. Over the next five years, one of these bonds will mature each year.
- Each bond is held at an equal weight.
The table below highlights the yield on each bond in the first year. We can compare three scenarios to illustrate what happens in various interest rate environments:
- Yields remain unchanged.
- Yields fall by 100 basis points (bps) across all maturities during Year 1.
- Yields rise by 100 bps across all maturities during Year 1.
| Maturity | Yields in Year 1 Scenario 1 |
Yields fall 100 bps in Year 1 Scenario 2 |
Yields rise 100 bps in Year 1 Scenario 3 |
|---|---|---|---|
| 1 | 1.00% | 0.00% | 2.00% |
| 2 | 1.20% | 0.20% | 2.20% |
| 3 | 1.40% | 0.40% | 2.40% |
| 4 | 1.60% | 0.60% | 2.60% |
| 5 | 1.80% | 0.80% | 2.80% |
For illustrative purposes only.
Rising yields and the long-term investor
Now let’s look at how the bond portfolio performs over 10 years. We will assume:
- Each year, a maturing bond is replaced with a new 5-year bond.
- The yield on each bond is 20 bps higher for each additional year of term.
We can use these assumptions to chart out the total return potential you’d see if you invested under each of the scenarios we’ve created.
- Scenario 1: Yields remain unchanged (dark blue).
- Scenario 2: Yields fall by 100 bps across the curve during Year 1 (yellow).
- Scenario 3: Yields rise by 100 bps across the curve during Year 1 (light blue).
Source: RBC GAM. For illustrative purposes only.
As the chart illustrates, the falling interest rate environment in scenario 2 is the most beneficial initially. When interest rates fall, bond prices rise, thereby increasing the market value of the portfolio.
Meanwhile, the rising rate portfolio in scenario 3 experiences an initial decline in value as rates rise. However, as time passes, the portfolio hurt by rising rates begins to perform more strongly, while the portfolio that experiences a drop in rates falls behind the original portfolio.
This is because over time new bonds are purchased at higher yields and so the portfolio earns more income than it would have under a scenario where rates remain unchanged. In a scenario where yields drop, the assets are reinvested at lower rates and therefore earn less over the full lifespan of this investment.
These three scenarios may be simplistic, but they highlight how fixed income portfolios can benefit from rising rates over time as the portfolio is reinvested. Although it may be unsettling to see negative rates of return on bond portfolios when yields are rising, having an adequate time horizon and reinvesting at higher rates can be beneficial to overall fixed income returns.