What does another Fed rate hike mean for bond holders?

Economy is in ‘great shape’: U.S. Federal Reserve
WATCH: The U.S. economy is in "great shape," says the U.S. Federal Reserve.

The U.S. Federal Reserve raised its key interest rate target by another quarter of a percentage point today, to a range between two per cent and 2.25 per cent. It’s the eighth increase since late 2015.

What does this mean for small investors who have part of their savings tied up in bonds?
The short answer is nothing. The markets have long been anticipating this hike, meaning they have already adjusted for it. Experts predict minimal impacts from today’s move if any.
What matters is how the markets react to clues from the Fed about the pace of future interest rate hikes, the ones investors have yet to price in. Economists expect several more hikes, including, possibly, one more later on this year.
Story continues below advertisement
This will affect bond holdings because in general, when interest rates go up, bond prices go down. And what the Fed does affects both the U.S. and global markets.
Canadians also have to worry about their own central bank, as the Bank of Canada appears likely to increase its own trend-setting interest rate at its next meeting on Oct. 24. While this move has also largely been priced in, Canadians likely face several more hikes.
WATCH: A look back on past interest rates in Canada
A look back on past interest rates in Canada
A look back on past interest rates in Canada

The inverse relationship between interest rates and bond prices

When rates go up, bond prices usually go down. When rates decline, bond prices increase.
Story continues below advertisement
In case you’re wondering, bonds are a type of investment in which an investor lends money to a company or government entity for a set period of time. Bonds pay a fixed or variable interest rate at specific intervals called the coupon rate.
New bonds are issued with the coupon based on prevailing interest rates. So if you have a bond with an annual coupon rate of five per cent, and rates climb, new bonds with a six per cent coupon are going to look more attractive. Demand for bonds with lower rates will diminish, bringing down their price.
How much bonds move up or down in response to interest rates has a lot to do with their maturity dates. In general, the longer the term of your bond, the steeper the price drop if rates go up.
Here’s one way to think about it: Let’s say that you bought your five per cent bond with a maturity date of 10 years. Now suppose that, a little over year later, interest rates go up to six per cent. This means you’re facing nine annual payments in which you’ll be getting a five per cent return when you could have gotten at least six per cent. But if you had a short-term five per cent bond maturing in two years, you’d only be underpaid once.
Story continues below advertisement
WATCH: How interest rate hike will affect your mortgage
How interest rate hike will affect your mortgage
How interest rate hike will affect your mortgage

So what does this mean for your investments?

“Bond investors who anticipate rate increases over the next year or two or longer would be in a safer spot with shorter-term bonds or bond funds that hold shorter-term bonds,” said Larry Bates, a veteran Bay St. investors and author of Beat the Bank: The Canadian Guide to Simply Successful Investing.

But it’s not all bad news for long-term bond investors.

“It’s sort of this funny contradiction in the bond world,” said Bates. “If you’re a long-term investor in bonds and interest rates go up, the value of your bond portfolio drops. But bit by bit over time, your returns on your bonds increase because as the old bonds in your fund mature, they buy newer bonds at higher yields.”

Story continues below advertisement

In other words, the short-term impact is going to be negative, but in the long run the impact of higher interest rates could be “very positive,” Bates said.

And to be clear, if you’re holding bonds to maturity, rising rates don’t mean you’re losing money. You’re simply missing out on the opportunity to hold bonds with higher rates.

READ MORE: Some savings accounts could earn you more than a 5-year investment right now

The takeaway for small investors?

Do nothing, according to Benjamin Felix, associate portfolio manager at PWL Capital in Ottawa.

No inexperienced retail investor should be picking bonds on their own, Felix said.

“Bonds are relatively hard to understand and relatively difficult to trade,” he said.

WATCH: Should you use a robo-advisor to invest?

Money 123: Should you use a robo-advisor to invest?
Money 123: Should you use a robo-advisor to invest?

But bonds can help soften the impact of market downturns on your portfolio. When the stock market crashes, bonds have usually done less badly or even well, Felix noted.

Story continues below advertisement

The way to go, he said, is bond index funds, which come with lower fees than actively managed bond funds (much like exchange-traded funds that track the stock market have lower costs than mutual funds).

Something like the FTSE TMX Canada Universe Bond Index, which gives you exposure to both short-term and long-term bonds, is probably a sensible option for many people, Felix said.

“But you have to understand that a shorter-term bond fund might never go more than one per cent into negative territory, but a universe bond fund could go down … four or five per cent or more.”

Above all, though, the most important thing is not to change your portfolio because of interest rate forecasts, he said.

“Your savings strategy and your savings rate is far more important than interest rates.”