Money Matters with Ken Moraif

What Happens with Bonds When Interest Rates Go Up? (It May Not Be What You Think)

Posted on . Category | Stock Market

The Federal Reserve will very likely raise interest rates soon. You may have heard that bond values go down when interest rates rise. Not necessarily: Not all bonds are hurt by higher interest rates, and some actually go up. It depends on the type of bond.

When consistent with their investment objectives, we may advise our clients to have one or more of four different types of bonds in their portfolios. The first two are American bonds, denominated here in the United States. Core fixed income bonds are basically U.S. government agency-related bonds, like treasuries, or Fannie Mae and Freddy Mac. They are generally considered the safest bonds in the world. The second type of American bond is a high-yield bond (they used to be called “junk bonds”). These are corporate bonds, where investors essentially lend money to U.S. corporations. The other two types of bonds that we may recommend are foreign bonds: established country bonds, which are bonds from Europe, Japan, Australia, etc.; and emerging market bonds, from countries with economies that aren’t considered well established, like China, or certain countries in Latin America or Africa.

Historically, these different types of bonds have reacted differently to rising interest rates. In those circumstances, U.S. government-denominated securities and established foreign country bonds usually go down, but high-yield bonds tend to go up. Why? The Fed usually raises interest rates because the economy is growing fast. If you look at history, you’ll see that higher interest rates go hand in hand with a good stock market. It makes sense: When the economy does well, corporations usually make profits. And when corporations make profits, then loans to those corporations become less risky, therefore high-yield bonds tend to go up. Foreign emerging market bonds also tend to do well in times of rising interest rates.

As you can see, it’s important to be diversified in your bond portfolio. You can't pick just one because things can change in the blink of an eye. Right now we think the Fed will raise rates, but maybe they won’t. Or maybe the situation will be reversed in few months. Even if the Fed raises interest rates, I generally believe that all four types of bonds can be useful, provided they are diversified according to your risk profile.

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