The Federal Reserve might raise interest rates next year. They last hiked interest rates in 2018, raising the fed funds rate four times from 1.50% to 2.50%. The relationship between bond prices and interest rates is like a see-saw in a park; when one side rises, the other side falls. If interest rates are rising, why would you buy bonds? A rate rise will indeed disrupt prices. However, disruption is where bond buyers can find opportunities.
The 30-Year US Treasury Bond yields 2.09%. If interest rates rise one percent, the price will fall 19.4% from $100 to $80.62. If you purchase the bond at $80.62, you have an opportunity to earn 24% when it matures to $100. In addition, the current yield improves to 2.6%. Since 1926, long-term government bonds have produced an average annual return of 5.8%.[1]
Bond and bond funds are considered lousy investments when interest rates rise. However, investors assume, incorrectly, that fund managers do nothing while rates are rising. When rates rise, fund managers buy bonds at lower prices while locking in higher rates. Eventually, lower bond prices and higher coupons will benefit shareholders.
The Franklin U.S. Government Securities Fund (FKUSX) originated in May 1970, and since its inception, it has delivered an average annual total return of 5.85%. Its best year was 1982, returning 33.04%, and its worst year was 1980, losing 12.87%. A $100,000 investment in May 1970 is now worth $1,827,300.[2]
When rates rise, the first reaction for bondholders is to sell. When they sell, it creates buying opportunities for investors with a long-term time horizon. You can take advantage of panic sellers by purchasing bonds at favorable prices. Their pain will be your gain.
Why buy bonds when interest rates climb?
- Lower prices
- Higher yields
- Better total return
- More bond investment choices
Don’t fear a rate rise. It will treat you well in the long run.
“The Chinese use two brush strokes to write the word ‘crisis.’ One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger–but recognize the opportunity.” ~ John F. Kennedy.
October 23, 2021
Bill Parrott, CFP®, is the President and CEO of Parrott Wealth Management in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process so our clients can pursue a life of purpose. Our firm does not have an asset or fee minimum, and we work with anybody who needs financial help regardless of age, income, or asset level. PWM’s custodian is TD Ameritrade, and our annual fee starts at .5% of your assets and drops depending on the level of your assets.
Note: Investments are not guaranteed and do involve risk. Your returns may differ from those posted in this blog. PWM is not a tax advisor, nor do we give tax advice. Please consult your tax advisor for items that are specific to your situation. Options involve risk and aren’t suitable for every investor.
[1] Dimensional Fund Matrix Book 2021.
[2] YCharts