What rising rates may mean for bond investors

Here are 4 reasons why investors should keep rising rates in perspective.

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  • Even in a rising-rate environment, investment-grade bonds may provide positive performance when stocks struggle.
  • While rising rates hurt bond prices in the short term, for long-term investors the higher interest payments can eventually benefit performance.
  • Even when investment-grade bonds have experienced losses, the price drops have not been of the same magnitude as stocks have seen during bear markets.
  • Despite rate risk, hiding in cash has historically often proven costly.

When interest rates rise and bond prices fall, it's natural for investors to be concerned. But short-term headwinds don't change the important role US investment-grade bonds can play in a portfolio. If you have a diversified portfolio that makes sense for your investment goals, time horizon, and financial circumstances, you can probably ignore the short-term concerns about a rate rise and stick with your plan.

Still worried? Here are 4 features of US investment-grade bonds that may help you maintain perspective.

1. Even in a rising-rate environment, bonds may still perform when you need them

Even in a period when bond returns may struggle in general, they can still play an important diversifying role in a portfolio, because they may rally at times when stocks fall—say, in the event of a crisis, economic slowdown, or other unforeseen market shock.

2. Over the long term, rising rates can help bond portfolio performance

In a portfolio of bonds, old bonds are maturing or being sold and new bonds are being added. When rates rise, it will generally cause the price of the bonds in the portfolio to fall, but the income from new bonds will be higher, and that added income has the potential to more than offset price losses over time—provided you stay invested.

That's why the amount of time you plan to invest is important when it comes to bonds. Bonds and bond funds with shorter durations reach the point where additional income offsets price losses faster, so they may be more appropriate if you need the money sooner. On the other hand, longer-duration investments may be more appropriate for diversification in a portfolio designed to meet long-term investment goals.

3. Even when bonds experience losses, the price swings aren't generally like stocks

Investment-grade bonds have historically tended to suffer smaller losses than stocks, and they very rarely post losses over longer time periods. Performance varies greatly for bonds of different credit qualities, but even during the worst bear market for bonds, the 40-year period of rising rates from 1941 to 1981, the worst 1-year loss for the Bloomberg Barclays US Aggregate Bond Index was just 5%. Over a 5-year period, the bond index never posted a loss. These performance numbers don't account for inflation—which can be an important consideration when evaluating investment performance—but they do illustrate the different magnitudes of price swings between stocks and bonds.

Of course, if you hold individual bonds to maturity, you may be able to ride out price fluctuations, knowing that as long as the bond issuer doesn't default, you will get your principal back at maturity and interest payments along the way.

4. Hiding can cost you

If you are worried about rising interest rates, you may be tempted to move out of bonds into cash. If so, you might avoid the risk that rising rates could hurt the value of your bonds, but what about inflation? Over time, a broadly diversified index of US investment-grade bonds has produced positive returns (after accounting for inflation) far more frequently than cash (see the chart below).

Moving money to the sidelines won't help manage the risk of declining purchasing power.

What you could do

You may have more bonds in your portfolio than you are comfortable with, or your particular bond holdings may leave you more exposed to interest-rate risk than you might like. But that's not true for everyone. Start by comparing your current portfolio with your investment strategy using Fidelity's Planning & Guidance Center.

The bottom line

It has been a long time since investors faced a sustained period of rising rates, so it may come as news to be reminded that your bond funds could potentially lose money. Still, investment-grade bonds rarely lose money over longer time periods, even when rates rise. Reviewing your investment strategy is always a good idea, but we think bonds play a role in most portfolios, regardless of the rate environment.

Next steps to consider

Visit Fidelity's fixed income, bond & CD landing page.

Review your bond holdings and see your interest rate risk.

Visit the Learning Center for courses and videos.

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