How I Learned To Love Rising Interest Rates

August 10, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Dan Egan, director of behavioral finance and investing at the New York-based automated investing service Betterment.

Contrary to conventional wisdom, rising interest rates can be good for a bond portfolio.

Investors might think otherwise because of the mechanics of very basic bond math (when rates go up, yields go up and prices go down). But that’s not the whole story: A diversified bond basket can actually benefit when rates rise.

As an example, the light blue line on this graph is the return of VBMFX, a very close proxy of the Vanguard Total Bond Market fund (BND | A-94) over the subsequent two years from the date on the x-axis.

This allows us to map the performance of the bond fund to the interest rates represented by the dark blue line. The dark blue line is the risk-free rate, or the “effective federal funds rate,” which is what banks charge each other based on their deposits at the Federal Reserve, and the primary benchmark for interest rates. The gray periods highlight when interest rates were rising.

Over the past 25 years, the two-year rolling return of BND—a bond fund diversified by maturity, credit quality and geography—actually increases, not decreases, after interest rates rise.

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