CNBC Explains

Rising rates not always a win for bondholders

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There's no pleasing some market watchers on interest rates. When rates plummeted during and after the financial crisis of 2008, there were worries that retirees couldn't get enough yield to live on. Now that rates are likely to begin rising again this year—potentially as soon as next week's Federal Reserve meeting, though most economists don't expect the first hike to come until September or later—the worry is that rising rates will make the value of bonds fall so much that holders still get hammered.

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That is driving a short-term drop in bonds—the Barclays Aggregate U.S. Bond Index is down 1.7 percent so far this month—but history says it's no big deal. When interest rates rise in the U.S., investors take minor, quickly recovered hits in total return, or none at all. And the impact of a rising economy on corporate profits and stocks more than makes up for it before long.

Many investors may be confused about the relationship between bond prices and yields. Higher rates mean lower bond prices—it's called an inverse relationship. It's also taken on more importance with the anticipation that the Fed will soon raise interest rates. That's driven a mini exodus from bond funds in the last month. But a deeper look at the numbers suggests that what's coming may be less scary than many small investors think.

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Longer-term bonds lose more principal value than shorter maturities as rates rise. The higher-yielding the bond is, the less the relationship has tended to be. But in all classes, equally as important to the inverse relationship between bond prices and yields is this: Historical data shows the declines are small and soon reversed. The total-return losses are small because, historically, the lion's share of a bond's return has been income rather than principal gain. As the income rises, unless credit-quality deteriorates, the value of the bond is going to at least stabilize relatively quickly.

"The impact is pretty short and pretty mild," said Sam Stovall, U.S. equity strategist for S&P Capital IQ.

Here are some of the numbers to back that up.

The Fed began to raise interest rates in February 1994—and the total return on the Barclays Index was -2.9 percent for the year. Stocks wobbled, too, because of recessionary fears, Stovall said. But by 1995 both stocks and bonds were in the black—bonds rose 18 percent as the S&P 500 rose 34 percent and the Internet boom began.

When the Fed began to raise rates in June 1999 to cool off the Web boom, total returns on bonds dropped just 0.9 percent. A bubble-fueled S&P 500 rose just less than 20 percent. Sky-high stock valuations and the 2001 recession, not rates, would soon prove to be the market's biggest woes.

Coming out of that recession, bonds' total returns actually kept rising when the Fed began raising rates in 2004, with Barclays' index delivering 2.4 percent gains that year even as the Fed pushed the federal funds rate from 1 percent to 5.25 percent. Stocks rose 9 percent.

Even the 2013 "taper tantrum" that began when ex-Fed chair Ben Bernanke hinted at winding down the central bank's bond-purchasing program produced only a -2 percent total return in bonds for the year, as stocks rose 30 percent in calendar 2013, continuing to climb after Bernanke's comments.

Every time, bonds recovered their losses in the following year.

For a number of reasons, the response this time should be more muted, if anything.

The central bank has made a point of telegraphing its intentions, so no one in the market could be surprised by the idea that the Fed is likely to raise rates. That suggests most of the impact of an early tightening is already built into prices.

Secondly, interest rates are not going to rise rapidly. The Fed has emphasized repeatedly that it will move carefully, and no member of the Fed is forecasting a gain in the Fed funds rate nearly as sharp as what happened in 2004. To the extent that other rates follow, their change should be minor as well.

That said, the kind of bond or stock investors choose can have a big impact.

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In 2013, Treasury bonds with 20 or more years to maturity lost almost 14 percent of their value (before returning 27 percent in 2014). Investors scared by volatility might prefer municipal bonds, which lost just 2.6 percent that year, or U.S. corporate bonds that delivered a -1.5 percent aggregate return, according to data provided by Barclays.

All of those classes recovered all of their lost value in 2014, when the aggregate bond index rose 6.0 percent.

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In stocks, utilities, telecom players and financial companies have declined when 10-year Treasury rates rose, Stovall said, citing data back to 1970. The biggest winners have been technology companies, followed by energy and materials companies.

The bottom line is that rising rates do add some forms of risk, but they are typically short-lived and relatively easy to avoid.