What will happen to bonds if interest rates go up? EDITED TO INCLUDE 10 YEAR RATE

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What will happen to bonds if interest rates go up? EDITED TO INCLUDE 10 YEAR RATE

Post by novolog »

What would happen to bonds if the fed funds rate goes up for an extended period of time (longer than 5 years)? Seems like rates have only ever gone down for the past 3 decades.

https://fred.stlouisfed.org/series/fedfunds

10 year rate: https://fred.stlouisfed.org/series/DGS10/

EDIT:

Let's say theoretically rates across the curve go up steadily for the next 2 decades (they don't stablize). Wouldn't that mean any bond (not bond fund) created during that period (in addition to any bond created before it) would lose value the rest of that 2-decade time period. And if this is the case, doesn't this mean that bond funds would go down as well because any new bonds added to the fund would be worth less as well (lower return than government debt)?
Last edited by novolog on Fri Oct 22, 2021 1:30 pm, edited 2 times in total.
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Re: What will happen to bonds if interest rates go up?

Post by Ramjet »

Bond prices will go down, but when rates stabilize you will then get paid at that higher rate. Many bond funds list what investment time horizon the fund is meant for because of scenarios just like this
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Re: What will happen to bonds if interest rates go up?

Post by dbr »

For one thing read here: viewtopic.php?f=10&t=360575

Take a look at this article in the Wiki: https://www.bogleheads.org/wiki/Bonds:_ ... s#Duration

Finally be aware that Fed Funds Rate and bond interest rates in general are two completely different things.

One point of interest is the yield curve: https://stockcharts.com/freecharts/yieldcurve.php

and the Treasury real interest rate data: https://www.treasury.gov/resource-cente ... =realyield

I personally prefer envisaging the effect of interest rate variation not as an influence on expected return but as an influence on risk in the sense that volatility in interest rates is translated by duration into volatility of return.
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Re: What will happen to bonds if interest rates go up?

Post by novolog »

Ramjet wrote: Fri Oct 22, 2021 11:44 am Bond prices will go down, but when rates stabilize you will then get paid at that higher rate.
this would only apply to bonds issued after the higher rates occur correct?
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Re: What will happen to bonds if interest rates go up?

Post by Ramjet »

novolog wrote: Fri Oct 22, 2021 11:51 am
Ramjet wrote: Fri Oct 22, 2021 11:44 am Bond prices will go down, but when rates stabilize you will then get paid at that higher rate.
this would only apply to bonds issued after the higher rates occur correct?
Yes, this will happen automatically if you own a bond mutual fund or ETF
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Re: What will happen to bonds if interest rates go up?

Post by novolog »

dbr wrote: Fri Oct 22, 2021 11:46 am Finally be aware that Fed Funds Rate and bond interest rates in general are two completely different things.
so the fed funds rate does not influence bond interest rates?
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Re: What will happen to bonds if interest rates go up?

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novolog wrote: Fri Oct 22, 2021 11:54 am
dbr wrote: Fri Oct 22, 2021 11:46 am Finally be aware that Fed Funds Rate and bond interest rates in general are two completely different things.
so the fed funds rate does not influence bond interest rates?
It's complicated.

You can do research here: https://www.bing.com/search?q=effect+of ... 6568dd3d6a
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Re: What will happen to bonds if interest rates go up?

Post by nisiprius »

The "Fed funds" rate is almost irrelevant in itself, because it represents an interest rate for an overnight loan. The Vanguard Total Bond Market fund has an average maturity of 8.7 years, so the appropriate thing to look at is the interest rate for loans of about that length, such as the 10-year Treasury rate.

The "Fed funds" rate is effectively set by the Fed. The 10-year rate is set by the market. The Fed can influence it, but doesn't control it. The rates for overnight loans and 10-year loans don't move in lockstep. That's why people look at and talk about "the yield curve."

I just finished posting an explanation of short- and longer-term effects of rising interest rates and you can find out more about the details of my simulation. It's not a precise, quantitative, numerical simulation of a real bond fund--it's a simulation of a rolling bond ladder--but it will show the main features.

It's hard to discuss things if we just talk about "up" and "down," but the main thing you need to understand is that "interest up, bonds down" is a short-term effect.

I don't know what you would want to guess for the future of interest rates. I cannot stress this too much: people do not know what interest rates will do, they do not even make good guesses, and all confident-sounding statements that "interest rates can only go up" should be ignored.

Anyway. If, over the next few years, interest rates rose 2% and stayed up forever, this is what would happen to a rolling bond ladder whose duration is similar to that of Total Bond. The effect of a permanent rise in interest rates is not a permanent fall in bond fund value.

Image

And skierincolorado has made a very important point. A rise in interest rates does not mean there will necessarily be any loss at all. It depends on "how far" but also on "how fast." If interest rates rise from 1.45% to 3%, and it is stretched out over five years instead instead of to, then there is actually no loss at all.

Image
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Re: What will happen to bonds if interest rates go up?

Post by novolog »

nisiprius wrote: Fri Oct 22, 2021 11:59 am The "Fed funds" rate is almost irrelevant in itself, because it represents an interest rate for an overnight loan. The Vanguard Total Bond Market fund has an average maturity of 8.7 years, so the appropriate thing to look at is the interest rate for loans of about that length, such as the 10-year Treasury rate.

The "Fed funds" rate is effectively set by the Fed. The 10-year rate is set by the market. The Fed can influence it, but doesn't control it. The rates for overnight loans and 10-year loans don't move in lockstep. That's why people look at and talk about "the yield curve."

I just finished posting an explanation of short- and longer-term effects of rising interest rates and you can find out more about the details of my simulation. It's not a precise, quantitative, numerical simulation of a real bond fund--it's a simulation of a rolling bond ladder--but it will show the main features.

It's hard to discuss things if we just talk about "up" and "down," but the main thing you need to understand is that "interest up, bonds down" is a short-term effect.

I don't know what you would want to guess for the future of interest rates. I cannot stress this too much: people do not know what interest rates will do, they do not even make good guesses, and all confident-sounding statements that "interest rates can only go up" should be ignored.

Anyway. If, over the next few years, interest rates rose 2% and stayed up forever, this is what would happen to a rolling bond ladder whose duration is similar to that of Total Bond. The effect of a permanent rise in interest rates is not a permanent fall in bond fund value.

Image

And skierincolorado has made a very important point. A rise in interest rates does not mean there will necessarily be any loss at all. It depends on "how far" but also on "how fast." If interest rates rise from 1.45% to 3%, and it is stretched out over five years instead instead of to, then there is actually no loss at all.

Image
Thanks for the clarification on fed funds rate vs 10 year t-bill, i suppose i meant 10 year t-bill in my post.

This all makes sense, basically the bond fund would slowly roll in new bonds to make up for the fact that all bonds (not bond funds) issued prior to the increase in 10 year rates are signficantly discounted now?

quick exercise:

Say for example you know for a fact that the 10 year rate is going to be at 4% or higher for the next 30 years. Wouldn't any bonds (not bond funds) issued with a 2% rate, for example, be pretty much worthless?
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Re: What will happen to bonds if interest rates go up?

Post by dukeblue219 »

novolog wrote: Fri Oct 22, 2021 12:09 pm Say for example you know for a fact that the 10 year rate is going to be at 4% or higher for the next 30 years. Wouldn't any bonds (not bond funds) issued with a 2% rate, for example, be pretty much worthless?
If the two were sold at the same fixed price there certainly wouldn't be demand for the 2% bill. However, you might pay 80 cents on the dollar for those bills assuming that ten years worth of interest at a lower rate will be made up for at the end when you get back the full dollar.

Consider a 1 year bond that pays 0%. Is it worthless in an environment where savings accounts pay 10% interest? Of course not. Its worth around 90 cents on the dollar.
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Re: What will happen to bonds if interest rates go up?

Post by nisiprius »

novolog wrote: Fri Oct 22, 2021 11:54 am
dbr wrote: Fri Oct 22, 2021 11:46 am Finally be aware that Fed Funds Rate and bond interest rates in general are two completely different things.
so the fed funds rate does not influence bond interest rates?
This will explain it better than words.

Go to the dynamic yield curve web page.

Image

Put your mouse down on the yellowish "S&P 500" chart. Drag your mouse to the right, then to the left. You are changing the date for which the yield curve is displayed. Watch the yield curve wiggle around. The left end shows short-term interest rates, 3 months. (The Fed funds term is overnight, but not terribly different). The 7-year and 10-year rates are more or less what an intermediate-term bond fund responds to.

Really do it. It's ten minutes well spent, really.

So think left end, Fed. How much "influence" does it have on the rest of the curve?

"Some."

For a specific example, try 2004 to 2007, when the Fed raised the Fed Funds rate from 1% to 5.25%.

How much did the left end, the 3-month rate rise?

How much did the 7-year and 10-year rates rise?

The Fed is part of the market, and exerts its influence by operations within the free market, but longer rates are set by the market.

Image

In other words, ignore overconfident talk about what the Fed is absolutely sure to do, because "those who talk don't know, and those who know don't talk." And ignore overconfident talk about what that is going to mean for bond funds "when" they do it, because that is a chain whose links are rubber bands.
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Re: What will happen to bonds if interest rates go up?

Post by Taylor Larimore »

novolog wrote: Fri Oct 22, 2021 11:32 am What would happen to bonds if the fed funds rate goes up for an extended period of time (longer than 5 years)? Seems like rates have only ever gone down for the past 3 decades.

https://fred.stlouisfed.org/series/fedfunds
novolog:

You should find your answer here (third column).

Best wishes.
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Re: What will happen to bonds if interest rates go up?

Post by novolog »

nisiprius wrote: Fri Oct 22, 2021 12:27 pm
novolog wrote: Fri Oct 22, 2021 11:54 am
dbr wrote: Fri Oct 22, 2021 11:46 am Finally be aware that Fed Funds Rate and bond interest rates in general are two completely different things.
so the fed funds rate does not influence bond interest rates?
The Fed is part of the market, and exerts its influence by operations within the free market, but longer rates are set by the market.
Is this because they literally cannot affect anything other than the short end of the curve, or because they have chosen not to. Is there anything stopping the fed from buying longer term treasuries if they chose to?

edit: Thank you btw for that interactive chart, extremely fun to play with
Last edited by novolog on Fri Oct 22, 2021 12:52 pm, edited 2 times in total.
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Re: What will happen to bonds if interest rates go up?

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novolog wrote: Fri Oct 22, 2021 12:48 pm
nisiprius wrote: Fri Oct 22, 2021 12:27 pm
novolog wrote: Fri Oct 22, 2021 11:54 am
dbr wrote: Fri Oct 22, 2021 11:46 am Finally be aware that Fed Funds Rate and bond interest rates in general are two completely different things.
so the fed funds rate does not influence bond interest rates?
The Fed is part of the market, and exerts its influence by operations within the free market, but longer rates are set by the market.
Is this because they literally cannot affect anything other than the short end of the curve, or because they have chosen not to. Is there anything stopping the fed from buying longer term treasuries if they chose to?
You mean this: https://en.wikipedia.org/wiki/Quantitative_easing
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Re: What will happen to bonds if interest rates go up?

Post by novolog »

dbr wrote: Fri Oct 22, 2021 12:50 pm
novolog wrote: Fri Oct 22, 2021 12:48 pm
nisiprius wrote: Fri Oct 22, 2021 12:27 pm
novolog wrote: Fri Oct 22, 2021 11:54 am
dbr wrote: Fri Oct 22, 2021 11:46 am Finally be aware that Fed Funds Rate and bond interest rates in general are two completely different things.
so the fed funds rate does not influence bond interest rates?
The Fed is part of the market, and exerts its influence by operations within the free market, but longer rates are set by the market.
Is this because they literally cannot affect anything other than the short end of the curve, or because they have chosen not to. Is there anything stopping the fed from buying longer term treasuries if they chose to?
You mean this: https://en.wikipedia.org/wiki/Quantitative_easing
OK so maybe my initial post should have included this graph as well:

https://fred.stlouisfed.org/series/DGS10/

In general it seems the fed can influence any part of the yield curve if it chooses too.

It seems that bond funds would eventually level out if there was an increase in rates and then a stabilization based on conversation thus far.

let's say theoretically rates across the curve go up steadily for the next 2 decades (they don't stablize). Wouldn't that mean any bond (not bond fund) created during that period (in addition to any bond created before it) would lose value the rest of that 2-decade time period. And if this is the case, doesn't this mean that bond funds would go down as well because any new bonds added to the fund would be worth less as well (lower return than government debt)?
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Re: What will happen to bonds if interest rates go up?

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novolog wrote: Fri Oct 22, 2021 1:09 pm let's say theoretically rates across the curve go up steadily for the next 2 decades (they don't stablize). Wouldn't that mean any bond (not bond fund) created during that period (in addition to any bond created before it) would lose value the rest of that 2-decade time period. And if this is the case, doesn't this mean that bond funds would go down as well because any new bonds added to the fund would be worth less as well (lower return than government debt)?
I'm not an expert on bond by any stretch of imagination here, but your question got me to wonder - what kind of economic conditions/environment would we have to see to cause rates across the entire curve go up constantly for the next 2 decades?

Doesn't Fed usually raise rates when we see equity markets do very well? And decrease rates in react to poor equity markets?

If it is like that (someone smarter than me will correct me if I'm wrong, and I probably will be corrected soon), then I would think that seems like a "good problem" to have. Rates being increased constantly for the next 2 decades would suggest it was probably due to our equities being on a tear for the next 2 decades.

Edit: Very brief research, I'm probably wrong. Fed would increase rate in reaction to rising inflation concerns, to encourage consumers to spend less (because of higher cost to borrow). But I'm kind of curious about the correlation between hot equity markets and inflation. Does inflation and well-performing equity markets usually go hand-in-hand?
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Re: What will happen to bonds if interest rates go up?

Post by nisiprius »

novolog wrote: Fri Oct 22, 2021 1:09 pmlet's say theoretically rates across the curve go up steadily for the next 2 decades (they don't stablize). Wouldn't that mean any bond (not bond fund) created during that period (in addition to any bond created before it) would lose value the rest of that 2-decade time period. And if this is the case, doesn't this mean that bond funds would go down as well because any new bonds added to the fund would be worth less as well (lower return than government debt)?
On your chart, rates went up about 10% over a period of about 20% per year, or about 0.5% per year.

So...

Image

Since there's no limit to what one can hypothesize for an interest rate regime, you can't put limits on what could possibly happen. But, no, if interest rates were to go up steadily at 0.5% per year for the next twenty years, a bond fund would not "lose value" throughout the two-decade period while the interest rate was rising.

In the real world, bond funds did make money during the period of rising rates, but experienced a serious loss of real value due to inflation. This Morningstar chart shows both a specific fund, the Putnam Income Fund, and the Morningstar category average for "core-plus bond funds."

Source

Image

Inflation is bad. Rising interest rates in themselves are just not the bogeyman they are made out to be, at least not for a retail investor in a "normal" core bond fund.
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Re: What will happen to bonds if interest rates go up?

Post by Tom_T »

nisiprius wrote: Fri Oct 22, 2021 1:35 pmIn the real world, bond funds did make money during the period of rising rates, but experienced a serious loss of real value due to inflation. This Morningstar chart shows both a specific fund, the Putnam Income Fund, and the Morningstar category average for "core-plus bond funds."
As an exercise, I looked at the Putnam Income Fund from the period 1/1/1977 to 12/31/1980. Why that period? The fund was born in late 1976. The 10-year Treasury began 1977 at 6.81%. By the end of 1980, it had soared to 13.98% - an all-time high for year-end close. I think we all agree that a rise of seven points in four years is considerable. I picked the 10-year for simplicity's sake; I don't actually know what made up the Putnam fund.

A $10,000 investment in the Putnam Income Fund at the beginning of 1977 was worth $10,344 at the end of 1980 based on total return.

Yes, with inflation, you're not doing well, but I think people have a mental image of their bond funds getting destroyed when rates go up a lot.
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Re: What will happen to bonds if interest rates go up?

Post by Ferdinand2014 »

novolog wrote: Fri Oct 22, 2021 12:09 pm
nisiprius wrote: Fri Oct 22, 2021 11:59 am The "Fed funds" rate is almost irrelevant in itself, because it represents an interest rate for an overnight loan. The Vanguard Total Bond Market fund has an average maturity of 8.7 years, so the appropriate thing to look at is the interest rate for loans of about that length, such as the 10-year Treasury rate.

The "Fed funds" rate is effectively set by the Fed. The 10-year rate is set by the market. The Fed can influence it, but doesn't control it. The rates for overnight loans and 10-year loans don't move in lockstep. That's why people look at and talk about "the yield curve."

I just finished posting an explanation of short- and longer-term effects of rising interest rates and you can find out more about the details of my simulation. It's not a precise, quantitative, numerical simulation of a real bond fund--it's a simulation of a rolling bond ladder--but it will show the main features.

It's hard to discuss things if we just talk about "up" and "down," but the main thing you need to understand is that "interest up, bonds down" is a short-term effect.

I don't know what you would want to guess for the future of interest rates. I cannot stress this too much: people do not know what interest rates will do, they do not even make good guesses, and all confident-sounding statements that "interest rates can only go up" should be ignored.

Anyway. If, over the next few years, interest rates rose 2% and stayed up forever, this is what would happen to a rolling bond ladder whose duration is similar to that of Total Bond. The effect of a permanent rise in interest rates is not a permanent fall in bond fund value.

Image

And skierincolorado has made a very important point. A rise in interest rates does not mean there will necessarily be any loss at all. It depends on "how far" but also on "how fast." If interest rates rise from 1.45% to 3%, and it is stretched out over five years instead instead of to, then there is actually no loss at all.

Image
Thanks for the clarification on fed funds rate vs 10 year t-bill, i suppose i meant 10 year t-bill in my post.

This all makes sense, basically the bond fund would slowly roll in new bonds to make up for the fact that all bonds (not bond funds) issued prior to the increase in 10 year rates are signficantly discounted now?

quick exercise:

Say for example you know for a fact that the 10 year rate is going to be at 4% or higher for the next 30 years. Wouldn't any bonds (not bond funds) issued with a 2% rate, for example, be pretty much worthless?
Technically a "T-Bill" is a Treasury bill - a maturity of less than 1 year. A Treasury Note has a maturity of 2-10 years and a Treasury Bond has a maturity of > 10 years. In general The duration of a bond fund gives you an idea of what happens to the capital value of the fund. A duration of 5 years means that a 1% rise in interest rates will cause a 5% capital loss until the new bonds with new interest rates are rolled into the bond fund over time. Dividends (interest) from the fund will also gradually rise to meet the new interest rate which is separate from the capital gain or loss of the fund itself.
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Re: What will happen to bonds if interest rates go up?

Post by jeffyscott »

dukeblue219 wrote: Fri Oct 22, 2021 12:13 pm
novolog wrote: Fri Oct 22, 2021 12:09 pm Say for example you know for a fact that the 10 year rate is going to be at 4% or higher for the next 30 years. Wouldn't any bonds (not bond funds) issued with a 2% rate, for example, be pretty much worthless?
If the two were sold at the same fixed price there certainly wouldn't be demand for the 2% bill. However, you might pay 80 cents on the dollar for those bills assuming that ten years worth of interest at a lower rate will be made up for at the end when you get back the full dollar.

Consider a 1 year bond that pays 0%. Is it worthless in an environment where savings accounts pay 10% interest? Of course not. Its worth around 90 cents on the dollar.
To further illustrate this...

If an existing bond had been issued with a 2% rate, then a $1000 bond is paying a coupon of $10 every 6 months. So if this bond has 10 year to maturity, the owner will get $10 every 6 months for those 10 years and then will get $1000. So a buyer of the bond is going to get a total of $1200 over the 10 year period.

If a newly issued 10 year bond has a 4% rate, the coupon payments will be $20. So the total that the bond holder will receive is $1400 over the 10 year period.

So as a first approximation, it might make sense to pay $857 for the existing 2% bond. Both bonds will then pay back 140% of the purchase price over the 10 years. This is an inaccurate estimate, due to the difference in the timing of payments, but it is not that far off from the actual expected market value of $836 based on this calculator: http://www.rrfinance.com/Fixed_Income/F ... .aspx?ID=2
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Re: What will happen to bonds if interest rates go up?

Post by Beensabu »

novolog wrote: Fri Oct 22, 2021 12:48 pm Is there anything stopping the fed from buying longer term treasuries if they chose to?
No. They've already been doing that.
novolog wrote: Fri Oct 22, 2021 1:09 pm let's say theoretically rates across the curve go up steadily for the next 2 decades (they don't stablize).
Rates never stabilize. They go up. They go down. They go up. They go down. That's what they do.

Sometimes, the NAV of your bond fund goes up; sometimes, it goes down. The fund just tries to hold the the most credit-worthy highest coupon bonds it can find at the right price, while maintaining its overall target duration.
cflannagan wrote: Fri Oct 22, 2021 1:16 pm I'm not an expert on bond by any stretch of imagination here, but your question got me to wonder - what kind of economic conditions/environment would we have to see to cause rates across the entire curve go up constantly for the next 2 decades?
Really high long-term inflation. And they'd still go down sometimes even if the longer trend was up.
cflannagan wrote: Fri Oct 22, 2021 1:16 pm Doesn't Fed usually raise rates when we see equity markets do very well? And decrease rates in react to poor equity markets?
It's more like when the economy is doing well, and we're at full employment. And vice versa. They only care about the market to the extent they need to keep the financial institutions functioning.
cflannagan wrote: Fri Oct 22, 2021 1:16 pmDoes inflation and well-performing equity markets usually go hand-in-hand?
No. "Death of equities" was called at the tail end of the last period of high inflation. Aug. 13, 1979 headline: “The Death of Equities: How Inflation Is Destroying the Stock Market.”
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