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The Short Answer

Are Your Bond Holdings Vulnerable in a Rising-Rate Environment?

The ‘duration stress test’ can serve you well in case interest rates go up.

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A version of this article was published on Sept. 17, 2015.

The Federal Reserve has signaled that it's planning to raise interest rates this year in an effort to cool down inflation. Some analysts are anticipating as many as four rate increases in 2022 alone.

Rising rates will have a ripple effect throughout the economy, as they make it more costly for companies to borrow. That has implications for stocks, of course--it hurts many types of businesses, though some, such as banks, stand to benefit.

Rising yields also have direct implications for investors in income-producing securities, both stocks and bonds. Dividend-rich(er) stocks like utilities and real estate investment trusts often fall in periods of rising rates, as investors flee those categories when more compelling yields come on line in bonds. Ditto for bonds, whose prices often decline when yields trend up.

It's definitely smart to think about what risks might lurk in your portfolio, particularly in segments that you expect to be drawing upon for living expenses within the next several years. And it's also true that after a few decades' worth of declining interest rates, rates have much more room to go up than they do to go down further. That could spell trouble for bond prices if rates head up. Indeed, expected Fed action is already weighing heavily on bond prices, causing losses in many high-quality bond funds.

At the same time, it's not a good idea to dump bonds altogether. Bond prices have already fallen a good bit, reflecting the likelihood that rates could go higher in the future; it's not as though the threat of rising rates is a new concept that no bond-market participants have considered. You never want to be too reactionary.

Moreover, shunning bonds carries risks of its own. Even high-quality stocks have a higher volatility profile than low-quality bonds. A worst-case scenario for stocks will equal much higher losses than you're apt to see in an Armageddon-type scenario in the bond market.

It also helps to keep bond worries in perspective. Yes, rising rates tend to depress the prices of already-existing bonds on the market. But if you own individual bonds, you can simply hold them to maturity and reinvest the proceeds into bonds with higher yields attached to them. Just make sure that you're adequately diversified and that you're not sinking too large a share of your portfolio into bonds with sketchy credit qualities. And if you own a bond fund, you may see your principal value decline, but those losses will be at least partially offset by the fact that the manager can swap into higher-yielding bonds as he or she goes along. Rising yields may eventually be good for bond investors, just not right away.

The Stress Test

To help assess the impact that rising rates could have on your bond portfolio, it's a good time to stress-test your bond holdings to see exactly how much interest-rate sensitivity is lurking there.

One common rule of thumb is that for every 1-percentage-point increase in Treasury yields, an investor could expect to lose an amount equal to the fund's duration. But Vanguard's former fixed-income head Ken Volpert once shared a useful refinement to that rule of thumb: To estimate how much an investor could lose during a 12-month period if Treasury yields increased by 1 percentage point during that same 12 months, subtract a fund's SEC yield from its current duration. That rule of thumb accounts for the fact that even though the uptick in rates leads to principal losses, the investor recoups part of that loss in the form of income during the 12-month period.

To use a current (and widely held) example, Vanguard Total Bond Market ETF BND currently has an SEC yield of 2% and an average duration of 7.0 years. That means that if yields increased by 1 percentage point during a one-year period, one could expect the fund to lose roughly 5% during that same time frame--the 7% expected loss of principal would be slightly mitigated by the fund's 2% yield. If yields increased by 0.25% during a one-year period, the fund would stand to earn a slightly positive return during that stretch. (A 7.0-year duration multiplied by the interest-rate increase of 0.25 equals a 1.75% loss of principal over the one-year period, but the investor also earns a 2.00% yield during that time, so the fund's one-year total return would be slightly positive.) Note that bond prices are already reflecting the expected Fed action, which is why most high-quality bond funds, including this one, are in the red for the year to date. When the Fed announces its actions, they'll have already been factored into bond prices, and in turn, bond-fund investors' returns.

Meanwhile, the projected losses for long-term U.S. Treasury bonds amid a period of rising rates look a lot more alarming, and that helps explain why recent results look so poor. Vanguard Long-Term Treasury ETF VGLT, for example, has posted a solid three-year annualized gain of 6%. But given the fund's duration of 18 years and yield of 2.2%, shareholders could expect to lose roughly 16% of their principal during a one-year period if Treasury rates were to jump up by 1 percentage point during that same time frame. The fund has dropped about 6% over the past year. This example illustrates that if you're concerned about rising rates, avoiding long-term bond funds is a good starting point.

Even as duration is a handy measure, there are some limitations of which you should be aware. Investors use changes in Treasury yields as a proxy for what’s happening with interest rates, and changes in Treasury yields are a good predictor of what you can expect from a Treasury fund’s performance. But other types of bonds won’t be as responsive to changes in Treasury yields. Thus, it’s a mistake to derive a false sense of precision from the aforementioned rule of thumb, particularly if you’re dealing with a bond type where there’s a substantial differential between its yield and that of Treasury bonds.

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.