Rising Interest Rates: Is There a Silver Lining?

On June 30, 2004 the Federal Reserve raised its target for short-term interest rates from 1% to 1.25%. The Fed also stated that it will continue to raise rates at a "measured pace" to keep inflation under control. These rate increases will ripple through the economy to increase the cost of credit card borrowing and adjustable-rate mortgages and boost money-market and CD yields. Longer term interest rates have already risen substantially since April in anticipation of the Fed's tighter monetary policy.

Interest rates have an inverse relationship with bond prices - when one goes up, the other goes down. As a result, bonds got slammed in the past three months, suffering one of the worst quarters in a decade. However, rising interest rates can also portend good news for bond investors due to higher returns on reinvested income.

To benefit from rising rates, you need to put your money to work at those higher yields. This is accomplished through continued bond purchases from new deposits or reinvested interest payments. For most investors, bond funds are the most efficient way to reinvest interest income because they allow you to purchase additional shares with small amounts of money.

Bond funds typically hold tens or hundreds of individual bonds with different maturities. These bonds generate periodic interest payments, resulting in a stream of cash distributions. Additional cash becomes available as each bond matures. The fund manager puts this cash to work by buying more bonds. Over time, the existing bonds in a fund are gradually replaced by new, higher yielding bonds. As a result, the short-term pain of higher interest rates (and declining bond prices) is eventually offset by higher yields.

How quickly you benefit from a rise in rates depends on the average maturity of your bond fund. Funds with short-term average maturities profit from rising rates relatively quickly as existing holdings are replaced with higher yielding bonds. Long-term bond funds undergo steeper price declines when rates rise and take longer to gain from reinvesting interest payments at higher yields.

At Shearwater Capital, we prefer short- and intermediate-term bond funds for most of our clients. Short-term funds have the advantage of increasing yields relatively quickly in a rising interest rate environment. Intermediate-term funds respond more slowly, but have higher yields over the long run. Long-term funds also have higher yields, but not enough to compensate for the increased interest rate risk for most individual investors.

July 2004

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