Higher interest rates can create a frustrating combination for fixed income investors: lower values on existing holdings and better yields on new investments. Understanding both sides can help you assess what a change on your statement means for your financial plan.
In our accompanying video, Andrew Samalin, CFP®, EA, CDFA®, Principal of Samalin Wealth, explains how interest rates affect fixed income and why your income needs and time horizon matter when reviewing your holdings.
Why fixed income values can fall when rates rise
Fixed income generally refers to investments such as government, municipal, and corporate bonds. When you buy a bond, you lend money to an issuer in exchange for promised payments.
Existing fixed-rate bonds generally become less valuable when market interest rates rise. Consider a bond paying 3% when comparable new bonds offer 5%. Buyers typically demand a lower price for the older bond to make its return competitive. If market rates fall, that relationship generally works in reverse. 1
This helps explain why the part of a portfolio intended to provide income can still experience price declines.
How duration affects your holdings
Fixed income investments respond differently to changing rates. Duration estimates how sensitive a bond or bond fund is to those changes. Generally, a higher duration means a larger price movement for a given change in yields.
For example, a fund with a duration of six years could experience an approximate 6% price decline if yields rise by one percentage point, all else equal. This is an estimate; credit conditions and other factors also affect returns. Duration is different from maturity, which is the date a bond becomes due.2
The difference between individual bonds and bond funds
For a traditional individual fixed-rate bond, rising market rates generally do not change its scheduled interest payments. If you hold it to maturity and the issuer meets its obligations, you receive its face value. That may differ from what you paid, particularly if you bought at a premium. Selling before maturity exposes you to the prevailing market price.1
Most traditional bond mutual funds and ETFs have no single maturity date at which they promise to return your original investment. Their share prices fluctuate, and distributions can change. Individual bonds maturing within a fund do not guarantee recovery of the fund investor’s purchase price.3
How higher rates can support future income
As bonds mature or holdings are replaced, a fund may invest at higher prevailing yields. Investors buying new bonds may also find higher income opportunities than were available at lower rates.
However, a higher quoted yield does not mean every payment from an existing investment immediately increases. A fund’s income depends on its holdings, reinvestment activity, expenses, and distribution policy.
Reinvesting distributions buys additional shares, potentially at lower prices. Those shares remain exposed to investment risk. Income may help offset a price decline over time, but it does not establish a recovery date or remove the possibility of further losses.
What a decline means for your financial plan
In the video, we introduce Linda, a hypothetical retiree with $400,000 allocated to fixed income. A 5% decline would reduce that allocation’s value by $20,000, before separately considering distributions.
That decline deserves attention. The next step is to evaluate the income those holdings produce, when Linda needs to withdraw money, and whether the investments still fit her plan. Looking only at the account value leaves part of the picture out; looking only at income does, too.
Before making a change, consider:
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Upcoming withdrawals: How much will you need, and when?
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Rate sensitivity: How much duration does your portfolio carry?
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Credit quality: How financially sound are the issuers behind your investments?
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Total return: What do income and price changes add up to after expenses?
Review your fixed income in context
A higher-rate environment can create both challenges and opportunities. The appropriate response depends on what you own and what you need that money to do.
At Samalin Wealth, we help individuals and families evaluate fixed income within their broader financial plans. If changes in your holdings have raised questions, contact us to schedule a brief call.
FAQ
When market interest rates rise, existing fixed-rate bond prices generally fall. Higher rates can also provide opportunities to earn more income on new investments or reinvested proceeds.
Yes. Bonds and bond funds can lose value because of changing interest rates, an issuer’s financial difficulties, or other market conditions. The level of risk depends on the investments you own.
An individual bond has a maturity date when the issuer is obligated to repay its face value, subject to its ability to pay. Most traditional bond funds have no single maturity date or promise to return your original investment.
Falling rates generally support bond prices, but a recovery is not assured. Your fund’s results also depend on its holdings, credit quality, expenses, and other market conditions.
A rate change alone does not determine whether you should make a change. Review your income needs, upcoming withdrawals, and investment risks within your overall financial plan.
Sources
1. SEC Investor Bulletin on interest rates and fixed-rate bond prices
2. Fidelity on duration and interest rate sensitivity
3. Investor.gov on bond funds and income funds
For educational purposes only; not individualized investment, tax, or legal advice. All investing involves risk, including possible loss of principal. Fixed income investments are subject to interest rate, credit, and other risks. Linda is a hypothetical example for illustration only and does not represent an actual client or investment result. Samalin Wealth is an SEC-registered investment adviser. Registration does not imply a particular level of skill or training.
