Rising Rates

Rising Rates and Bonds

Understanding why the U.S. Federal Reserve is raising the fed funds rate and what the changes may mean for bonds will allow investors to make more informed decisions.

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Voice over: Your money at work. Insights that can help you build a more secure future. Brought to you by PIMCO. People invest for many reasons, no matter what your personal financial goals may be. To reach them, you need to make sure your money is working hard and working smart. But with today’s complex global markets and so many investment choices available, it can be hard to decide what’s right for you. Making sense of a few basic concepts can help you make more informed decisions about investing. This video will help you get started.

Rising rates and bonds. When evaluating an investment, it is important to consider the economic and market conditions that may have an impact on its potential return. Take interest rates, for example. Following the financial crisis of 2008, the federal reserve pushed rates down to historic lows in an effort to jumpstart the economy. Now that the economy is improving, they intend to raise rates. Bond investors in particular will want to understand how fed policy works and what impact, if any, a rate increase might have on their investments.

There are many interest rates in the marketplace. The Federal Reserve controls the fed funds rates, or what is also known as the policy rate. This is the target rate for what US banks charge each other for overnight loans. Supply and demand in the market ultimately determines interest rates on longer-term loans, but changes in the fed funds rate can have a ripple effect, influencing the rate a business would pay to borrow money, for example, or the rate a homeowner would pay on a mortgage. The fed funds rate can also influence, to varying degrees, the yield on bonds.

Some investors might be concerned that increases in the fed funds rate may be bad for bond holders, since rising rates could drive up yield, which generally drives down a bond’s price. But that is not always the case. In fact, bonds can be a valuable part of your portfolio no matter what is happening with rates.

Consider these three points: first, it is important to know that different types of bonds react differently to changes in the fed funds rate. So while yields on short-term treasury bills tend to move in lockstep with the fed funds rate, yields on longer-term treasury bonds are generally less sensitive to the fed's actions. And then there are the other types of bonds, such as corporate bonds or non-US bonds, which may actually benefit if rising rates signal a strengthening economy. A professional active bond manager can be extremely useful in reacting to a changing rate environment.

Second, investors who focus on the long-term may be better off if rates rise. Take, for example, an investor who purchased a five-year treasury bond with a $1,000 face value and a 2% coupon. If interest rates went up, the treasury might start issuing new five-year bonds with the higher coupon rate, say 2.5%, pushing down the price of the older bond. After all, who would pay $1,000 for a bond-yielding 2% when you could pay $1,000 for a bond with a 2.5% coupon? But as long as the investor doesn’t sell his bond before maturity, he will still receive his expected total return. So he will get $20 per year for five years, plus his initial investment of $1,000, for a total of $1,100.

Moreover, with newly issued bonds paying coupons of 2.5%, the investor could benefit by reinvesting. And finally, remember that bonds can add value to a diversified portfolio regardless of the rate environment, including the potential for income, diversification, and stability.

When considering bond funds, be sure to consider PIMCO. PIMCO is a leader in bond investing, with a 40-year track record of successfully managing portfolios for corporations and individuals in a variety of rate environments.

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