digging deeper

Interest Rates: Risks and Opportunities

With the economy recovering and the Federal Reserve considering when to curtail or stop bond purchases, interest rates are likely to rise in the future. What does this mean for investors?

alling interest rates have increased bond and bond fund returns over the past four years due in part to unprecedented central bank intervention. The eventual rise of interest rates from historic lows is unlikely to burst a "bond bubble," however, and investors should continue to have exposure to fixed income investments. "We believe bonds should remain an important component of an investor's portfolio," says Mike Gitlin, director of Fixed Income at T. Rowe Price. "Bonds provide a regular stream of income and diversification, they are generally less volatile than stocks, and they can help investors achieve their long-term financial goals."

Bond investors have enjoyed favorable—in some cases excellent—total returns over the past four years. Bond prices have appreciated as Treasury interest rates have fallen to historic lows, and yields on lower-quality securities, in particular, have declined significantly since the end of 2008. Several factors have boosted bond prices, but investors have benefited in large part as the Federal Reserve has implemented unprecedented stimulus measures—including purchases of Treasuries and agency mortgage-backed securities—to lower interest rates, increase liquidity, and encourage economic expansion.

"While fixed income securities have performed well in recent years," Gitlin says, "we are mindful that this performance pattern is unlikely to continue indefinitely." He notes that bond valuations in many sectors are stretched, with interest rates at such low levels that the potential for meaningful bond price appreciation is limited. But he cautions that interest rate risk—the possibility that a decline in bond prices may negatively affect returns—shouldn't be the only factor determining an investor's exposure to fixed income. "While we feel it is important to highlight the reality of interest rate risk, we do not subscribe to the cataclysmic view that a ‘bond bubble' is about to burst or that investors should sell all of their fixed income investments before rates rise."

Interest rates are low for several reasons, including modest economic growth, high levels of unemployment, contained inflation expectations, and the actions of the Federal Reserve. It's possible that rates could stay low for some time. But with the economy recovering and Fed officials considering when the central bank should curtail or stop its asset purchases, interest rates likely will rise in the future from their ultra-low levels—and that shift will weigh on bond prices. "Our interest rate strategy and economics teams regularly make forward-looking projections of rates and yield curves, and these assessments are incorporated in our investment approach," Gitlin says. "Even when rates return to more normal levels, bonds will remain an important asset class, and we expect to continue finding good investment opportunities for income-seeking investors."

Fundamental research is a hallmark of T. Rowe Price's risk-aware investment approach. The firm's research teams analyze a bond issuer's financial situation and prospects thoroughly and independently before making any decision to buy or sell a security.

Investment professionals actively manage bond portfolios and analyze economic and market developments daily, as they strive to minimize risk while staying focused on their long-term objectives. Because fund teams cannot control the direction of interest rates, they typically do not make investments where a favorable outcome depends primarily on which way interest rates move. As a result, portfolio managers tend to keep a bond portfolio's duration—a measure of interest rate sensitivity—within a range relative to its benchmark. Says Gitlin, "If we determine that rates are about to rise significantly or for an extended period, we may decide to reduce our bond portfolios' duration to help preserve value for our investors."

The Performance of the 10-Year U.S. Treasury Since 1975
Yield to maturitythe internal rate of return of a bond held to maturityon medium-term bonds has fallen consistently over time.

Sources: Board of Governors of the Federal Reserve System, FRED, T. Rowe Price

This chart is for illustrative purposes only and not intended to represent the returns of any specific security. Past performance cannot guarantee future results.

illustration by neil webb
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