You may remember the high interest rates of the ’80s and ’90s, but rates have declined since then. If you’re a fixed income investor, you might be surprised to discover this isn’t a positive trend for you.
Declining interest rates are generally favourable for those who hold fixed income investments like bond funds. However, when the economy starts to improve and central banks consider raising rates to more normal levels, fixed income investors may find their investments are negatively affected.
What seems counter-intuitive really isn’t. When interest rates rise, the value of bond funds goes down. That’s because the rates on the bond investments held in the funds are usually lower than what’s currently available in the market.
Not all fixed income products are affected the same way by shifts in interest rates. Short-term bond funds and other shorter-duration investments don’t react as aggressively to interest rate moves. The value of these products will still suffer in a rising interest rate environment, but not to the same extent as core bond funds and longer-duration investments. However, longer-duration products fare better in a declining interest rate environment.
It’s important to have a diverse investment portfolio even within fixed income investments. If you hold fixed income funds, consider balancing long-term funds with short-term fund options. Short-term fixed income funds should hold their value better than long-term funds, since their shorter timelines make them less sensitive to rising rates.