Why Long-Dated Bonds Underperform When Rates Rise

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What does this mean for bond investors? And what investing resolutions should you make in 2015?

Here are three we would offer:

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1.  Traditional bonds could experience losses.

For example, if we take a broad category of bond funds held by investors such as the Morningstar Intermediate Bond Category, a 1% rise in interest rates would mean approximately a 5% loss in principal. A 0.5% rise in rates could mean a 2.5% loss of principal, which would offset the income from the coupon payments and lead to overall losses. Longer maturity bonds hold more of this interest rate risk than shorter-maturity bonds, so be mindful of the maturities in your bond portfolio.

Market Realist – Long-dated bonds underperform when interest rates rise

The graph above compares the Treasury yield curve on December 1, 2014, with the yield curve at the start of the year. The graph suggests that longer-maturity bonds are more sensitive to interest rate movements. Particularly, Treasury bonds with a maturity of seven years or more (IEF)(TLT) seem to be more interest-sensitive. This is because an investor holding a long-dated bond is exposed to a lower coupon for longer.

Long-dated bonds underperform when interest rates rise. On the other hand, high yield bonds (HYG)(JNK) perform better than Treasuries when interest rates rise. You’ll fine more on this in the final part of this series. Investment-grade corporate bonds (LQD) also perform better.

The next part of this series explains why you should avoid TIPS in the new year.

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