How Changing Interest Rates Affect Fixed Income

It’s been a tough few months for bonds. Since early February, the yield on Government of Canada five-year bonds has climbed from 0.59% to about 1.07%, and 10-year bonds yielding 1.24% have ticked up to 1.82%. The seesaw relationship between yield and price means bond values have fallen sharply: over the same period broad-based index ETFs such as the Vanguard Canadian Aggregate Bond (VAB) have lost well over 3%.

A 3% decline over several months is modest—it’s a bad day for stocks—but bond investors have been so accustomed to steady gains in recent years that it’s caused a lot of anxiety. More worrisome, it’s revealed that many investors have some fundamental misunderstandings about the relationship between bonds and interest rates, which admittedly can be confusing. Inaccurate information leads to poor investment decisions.

If the last five years have taught us anything it’s that forecasting the direction of interest rates is futile, and countless armchair economists have paid the price for trying to do so. A better approach is to get out of the guessing business and simply understand the risks of various fixed income investments. Then you can make a rational decision about which ones are appropriate in your situation.

It’s also key to appreciate that short-term and long-term risks may differ: avoiding the possibility of loss in the short-term, for example, often comes with the risk of lower long-term returns. That’s why investors with a long time horizon can safely ignore the guru on BNN who only cares about his quarterly results and not your retirement plan.

The following table should help you understand the effect of changing interest rates on different types of fixed income investments, in both the short term and the long term. Since you can’t know where rates are headed in the future, the best you can do is understand what to expect from your fixed income holdings under both scenarios.

If interest rates fall If interest rates rise
Short-term bond fund Short term: The price of your holding will rise. If the fund has a duration of 3, it would rise in price by about 0.3% if short-term interest rates decrease by 0.1% (10 basis points).

Longer term: With rates on newly issued bonds now lower, reinvested interest and proceeds from maturing bonds will quickly have lower expected returns going forward.

Short term: The price of your holding will fall. If the fund has a duration of 3, it would fall in price by about 0.3% if short-term rates increase by 0.1% (10 basis points).

Longer term: With rates on newly issued bonds now higher, reinvested interest and proceeds from maturing bonds will quickly benefit from higher expected returns going forward.

Broad-based bond fund Short term: The price of your holding will rise, and more sharply than short-term bonds. If the fund has a duration of 8, it would rise in price by about 0.8% if interest rates decrease by 0.1% (10 basis points) across the board. The fund will be sensitive to changes in 5-, 10- and 20-year bond yields as well as short-term rates.

Longer term: With rates on newly issued bonds now lower, reinvested interest and proceeds from maturing bonds will gradually have lower expected returns going forward.

Short term: The price of your holding will fall, and more sharply than short-term bonds. If the fund has a duration of 8, it would fall in price by about 0.8% if interest rates increase by 0.1% (10 basis points) across the board. The fund will be sensitive to changes in 5-, 10- and 20-year bond yields as well as short-term rates.

Longer term: With rates on newly issued bonds now higher, interest and proceeds from maturing bonds will gradually benefit from higher expected returns going forward.

Five-year GIC ladder Short term: Unlike with bonds, you’ll see no increase in the value of your GICs. However, you can take comfort knowing that your GICs have rates higher than those currently offered.

Longer term: As each rung of the GIC ladder matures, you will need to reinvest the proceeds at lower rates. The overall yield on your ladder will therefore gradually decrease.

Short term: Unlike with bonds, you’ll see no decrease in the  value of your GICs. However, you’ll have some opportunity cost, as your GICs will be locked in for up to five years at rates lower than those currently offered.

Longer term: As each rung of the ladder matures, you will be able to reinvest the proceeds at higher rates rate. The overall yield on your ladder will therefore gradually increase.

Cash Short term: Unlike with bonds, you’ll see no increase to the value of your cash account. Banks may lower the rates on savings accounts almost immediately.

Longer term: Cash is almost guaranteed to lose to inflation, and you will likely pay a high  opportunity cost by avoiding bonds. If you were sitting in cash waiting to get back into the bond market, it backfired: the cost of doing so will be higher and expected returns  lower.

Short term: Unlike with bonds, you’ll see no decrease to the value of your cash account. Banks may raise the rates on savings accounts.

Longer term: Cash is almost guaranteed to lose to inflation, and you will likely pay a high opportunity cost by avoiding bonds. However, if you were sitting in cash waiting to get back into the bond market, you got lucky: the cost of doing so will be lower and expected returns higher.

61 Responses to How Changing Interest Rates Affect Fixed Income

  1. Carl May 23, 2015 at 11:49 am #

    @CCP: Thank you for your article. One question, what are your thoughts about the effect of interest rates changes on REIT etfs?

  2. Martin May 28, 2015 at 3:55 pm #

    Great article, Dan. Reading the article and through a few of your comments to readers really cleared things up on how bond funds work. Thank you.

  3. Ray June 6, 2015 at 5:06 pm #

    Hey Dan,

    I’m a first-time investor planning to begin a Couch Potato strategy next month. With all the turmoil surrounding the US Feds’ will/will not raise interest rates before 2016, is now the best time to jump in? I almost feel like a hitter in baseball, heading to the plate already down two strikes…

    I realize these kind of issues are like revolving doors for long-term investors and you need to expect or almost embrace volatility, but would I be better served waiting 3-8 months until the Fed has made up its mind and markets get over the initial shock? I feel like if I wait, I could at least take advantage of a dip (if there is one) and book a more favorable price. Although that’s easier said than done — and I’m far from a arbitrageur.

    I’m just curious how you would approach if you were in my position…

    Thanks in advance for your input and for all the quality material you provide.

    Regards,
    Ray

  4. Canadian Couch Potato June 7, 2015 at 3:02 pm #

    @Ray: It’s very common to feel like this any time you are investing a significant lump sum. It’s important to understand that it will never feel like a good time to invest a large lump sum. In theory, sure, investing a lump sum after a big dip in the markets is good idea, but almost no one has the discipline to do so. There will always be logical-sounding reasons to wait.

    As for, “I feel like if I wait, I could at least take advantage of a dip (if there is one),” don’t dismiss the possibility that the opposite could happen, markets will rise, and you will feel like you should wait another 6 to 8 months. The longer you wait, the harder it is to pull the trigger.

    My advice in this situation is to have a long-term plan in place first, then implement that plan with a full understanding of the possibility that it could have to endure some short-term losses. If you still cannot bring yourself to pull the trigger, invest the lump sum in three or four tranches, but with each date marked on the calendar so it is not subject to more guesswork.

  5. Ray June 7, 2015 at 5:21 pm #

    Yeah, I guess you can always find an excuse to wait. I’m not the type to panic if my investment loses say 5-10-20 per cent — it just sucks to almost expect that in the first six months. But oh well, I guess that’s the gamble.

    Thanks for the reply and keep the great material coming!

  6. Erick Brunet June 22, 2015 at 7:10 am #

    Thanks for the detailed and informative post! The comparison between the two predictions gives an excellent insight. Great job, Dan!

  7. NG December 5, 2015 at 2:38 pm #

    @CCP, Thanks for breaking this down for us, it’s quite helpful to be able to see this information presented in a table like this.

    I was wondering about discount bonds. I hold ZDB in a taxable account (all my tax-advantaged accounts are full of VAB, my asset allocation calls for more bonds, so I have to hold some bonds in taxable).

    I hold ZDB instead of VAB in my taxable account in order to have my portfolio be more tax efficient, as you have detailed in earlier posts.

    In a rising rate environment, I was wondering what to look out for, and when it makes sense to switch from discount bonds to a regular, aggregate bond ETF like VAB? I’m sure that there is some point at which it makes sense to do this, but am not sure how to recognize this point.

    Any insights you could provide would be helpful. Thanks a lot.

  8. Canadian Couch Potato December 6, 2015 at 8:02 am #

    @NG: Thanks for the great question. If interest rates continue to to fall, discount bonds will be harder and harder to find, and a fund like ZDB will find it difficult to remain well diversified. This has already happened to some extent, and the fund has broadened its mandate to include bonds that trade at a slight premium where necessary:
    http://canadiancouchpotato.com/2015/03/09/when-discount-bonds-are-hard-to-find/

    More relevant to your question, ZDB could become irrelevant one day if rates start to rise. There could be a time when there is no need for a discount bond ETF because traditional bond ETFs may all have that characteristic. If interest rates trend up for several years, then many bonds currently trading at par or a premium will eventually trade at a discount. You would see the gap between the fund’s average coupon (the amount of interest paid to investors) and the yield to maturity (the expected total return) gradually narrow. At some point the YTM of most ETFs could be higher than the coupon, which is precisely the goal of ZDB. At that point, all bonds would be relatively tax-efficient and it could make sense to switch to a more diversified, lower-fee ETF.

    This blog introducing ZDB may be helpful:
    http://canadiancouchpotato.com/2014/02/13/new-tax-efficient-etfs-from-bmo/

  9. Manny April 22, 2017 at 10:14 am #

    @CCP which vanguard ETF would you recommend for a good Canadian Short-Term Bond Index ETF? and are short-term bond index ETF a good idea or why not?

    Thanks

  10. Canadian Couch Potato April 22, 2017 at 10:53 am #

    @Manny: My model portfolios and recommend ETFs are available here. You are welcome to make any tactical moves or adjustments you wish.
    http://canadiancouchpotato.com/model-portfolios-2/
    http://canadiancouchpotato.com/recommended-funds/

Leave a Reply