Interest rates and bonds prices are inversely related; when interest rates rise, the value of a bond falls. Given that rates on US Treasury Bonds have climbed to levels we have not seen since 2011, bond prices are down year to date. As of November 1, 2018, the YTD returns on the Vanguard Total Bond Market Index Fund and the Dimensional Investment Grade Portfolio are approximately -2.5%.
So how long will it take for a portfolio to recover from a rise in rates? This depends in large part on the average maturity of the bond portfolio, but for now, let’s assume an investor makes a $10,000 investment in a bond fund with an average maturity of about 6 years. Now assume that over the course of the first year, interest rates increase to 6%. As a result, the portfolio will drop in value by about 10%, or to $9,000. Assuming all dividends are reinvested:
- By the end of year two, the investor would be above water relative to the initial investment with a bond portfolio valued at about $10,112.
- By about year 5, the investor will be at breakeven relative to where he would have been had rates stayed level at 4%.
- After 10 years, the investor will have about $16,118 versus the $14,800 he would have had assuming rates had stayed at 4%.
And this effect would be even more accelerated assuming an investor rebalances into bonds after a rise in rates.
So when rates are rising and you see the value of your bond fund decline, just remember that it’s not all bad news. Through the power of dividend reinvestment and patient rebalancing, a diversified bond portfolio with average maturity will recover in just a few years and actually produce higher returns in the long run.
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