What rising interest rates mean for bond funds

By Killian Plastow

June 23 2017
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The capital value of your bond portfolio will take a hit as interest rates begin to climb, but the amount of income it will yield will increase – so what do rate hikes mean for bond funds?

Zenith, BlackRock, Vanguard, fixed income, bonds, bond investing, fixed income investing, bond fund, Jon Howie, Andrew Yap, Nathan Zahm

In their recent Australian Fixed Interest Sector Review, research company Zenith said that investors will need to use a “range of investment strategies” to get the best results from the Australian fixed income sector.

The company’s head of income and multi-asset research Andrew Yap said a “common theme” within the sector was that the current US administration’s pro-business agenda would push the country’s rate of inflation up, which will likely drive inflation up in other G7 nations – including Australia.

Mr Yap said there is “greater scope to add value from active management” in the current rate environment, adding that inflation (or even just the expectation of inflation) can eat away returns from domestic bonds.

However, while Zenith suggests active management is the way forward, those involved in the passive bond fund market contend that the consequences of rising rates could be positive – especially for long-term investors.

“As the Zenith report has highlighted, over the short-term you will often see a reduction in the capital value of a bond portfolio because of rising interest rates,” Jon Howie, BlackRock’s head of iShares in Australia, told Nest Egg.

“But, when we look back at the last rate cycle in the US where interest rates went up between 2004 and 2006, while the price value of the overall bond benchmarks went down, the total return on those benchmarks actually was positive over that period, so for investors who are long-term in nature, what they receive was a greater positive return and overall income as rates went up.”

This view was also shared by Nathan Zahm, a senior investment strategist with Vanguard, who added that much like with passive share funds, passive bond funds simply reflect the market consensus on where bonds are heading.

“Bond pricing reflects everything that the market knows and believes about risk and the future,” he said.

“The market consensus, particularly for the United States, is for a rising rate environment, and so those that are buying bonds and participating in a fixed income market are paying prices with this knowledge in mind.”

Both Mr Howie and Mr Zahm said there was little reason for passive investors to be concerned by rising interest rates, but cautioned that investors need to understand the role such funds play in their overall portfolio and make sure it aligns with their financial goals.

“If you’re trying to achieve savings and to grow wealth over time, I think there’s an argument to say that you should be looking forward to rising rates,” Mr Howie said.

“If, on the flip side, you were a borrower and you’re trying to pay off a mortgage, then potentially rising rates could be a negative thing, but if we’re talking about savers and investors over the long-term, rising rates are potentially a good thing as they’ll earn more income over the longer term.”

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