by John DeBiase and Don Gould

Following last Friday’s employment report, which indicated increasing upward pressure on wages, anticipation of an initial rate hike from the Federal Reserve grew stronger. The consensus expectation is for an increase in the federal funds rate (the short-term interest rate controlled by the Fed) later this year, probably in September. Longer-term rates have already risen significantly – the yield on the 10-year US Treasury note is now at 2.39%, up from 1.68% in February.

When interest rates rise, bond prices fall.To understand how rising interest rates impact portfolio returns, it is important to understand how a change in rates affects the prices of existing bonds. Bond prices and interest rates move in opposite directions, so rising interest rates means lower bond prices. This happens because the interest rate on newly issued bonds is higher than before, making the fixed interest rate on existing bonds relatively less attractive by comparison. The longer the term of a bond, the more sensitive its price is to changes in interest rates.

Bond returns are the sum of the interest paid plus any change in the price of the bond. Since the immediate impact of rising interest rates on an investor’s portfolio is a drop in the price of their current bond holdings, this reduces overall bond returns. Over the long run, however, rising interest rates are actually a net positive for most investors. As bonds pay interest over time and eventually mature, the proceeds get reinvested into bonds with higher interest rates. For most investors, returns from those higher interest rates will eventually outweigh the initial drag on returns.

Rising interest rates can also weigh on stock market performance, as higher bond yields provide more competition for the investor’s dollar. However, the relationship between stocks and interest rates is complex and varies considerably, depending on what is driving rates higher. If rates are moving up primarily due to improved economic growth prospects, as seems to be the case, stocks could benefit from those same drivers.

Keep in mind that the Fed only directly controls the interest rate on the shortest-term obligations. Our analysis above assumes that longer-term interest rates will rise along with short-term rates. Perhaps anticipating the Fed’s move, longer-term rates have already risen significantly from their February lows. So it’s possible that when the Fed finally does make its move, bond yields will have already completed theirs.

Higher interest rates act as a near-term headwind on bond portfolio performance, but for most investors rising interest rates are ultimately good news. We welcome a time when investors can again earn a healthy yield on high quality bonds.