While interest rates have already increased considerably since the end of August, some investors remain concerned about potential additional increases as the monetary policies of the Federal Reserve become less accommodative. The immediate effect of a rise in interest rates is, of course, a drop in the value of fixed income investments, which has been very evident here in 2018. However, for investors with a longer time horizon, higher interest rates could actually mean better total returns.
To assess the potential magnitude of the benefit of reinvesting at higher returns, Nuveen Asset Management, LLC recently simulated the effects of higher interest rates on a portfolio consisting of the bonds in the Standard & Poor’s Municipal Bond Index. They estimated the total return that the S&P Municipal Bond Index would produce in four different scenarios involving rising interest rates over the next 10 years starting on March 20, 2018.
They assumed that on March 20, 2018, someone could invest in a portfolio that perfectly simulated the Standard & Poor’s Municipal Bond Index, but without any fees or expenses. They found that if interest rates were to rise by 1.00% the very next day, the portfolio would immediately lose over 5% of its value. However, as a result of the 1.00% increase in interest rates, the average yield of the portfolio would have risen from 2.70% to 3.68%.
Over time, the higher yields make up for the initial loss in value. They found that over the full 10-year period, the investment would have a total return of about 0.43% per year higher than had rates not increased at all. The result was generally the same in all four of the simulations they conducted, just to differing degrees.
So what is the takeaway? Long-term investors should not be worried about declining bond prices resulting from rising interest rates. Sure, nobody likes to see their bond values decline but those prices only matter IF one actually sells his or her bonds before maturity. For investors with sufficiently long time horizons, the benefit of getting a higher rate of return for the remaining life of their investments should outweigh the weak performance in the early years due to the initial losses. This is because the gain in income over time from increasing the yield is greater than the loss of principal value from the initial rise in interest rates. As such, we would actually welcome a rising interest rate environment even though we know the value of our bonds would initially suffer.
If you are interested in learning more about Nuveen’s study, follow the link below: https://www.nuveen.com/simulating-the-effects-of-rising-rates-on-municipal-bond-returns
