Yield ahead

The silver lining in rising rates 

November 10, 2021

How interest rates affect coupons and prices

Your investment horizon matters

Figure 1: Rising rates can be a good thing
A table shows changes in investment horizons of 5, 10, 15, 20, and 25 years and changes in interest rates of ‒200, ‒100, 0, 100, and 200 basis points for the hypothetical investment. When the investment horizon is 5 or 10 years and interest rates decline by 200 or 100 basis points, the expected change in the annualized total return for the hypothetical investment is positive. It is also positive when the investment horizon is 15, 20, or 25 years and interest rates increase by 100 or 200 basis points. However, when the investment horizon is 5 or 10 years and interest rates increase by 100 or 200 basis points, the expected change in the annualized total return for the hypothetical investment is negative. It is also negative when the investment horizon is 15, 20, or 25 years and interest rates decrease by 100 or 200 basis points. For all investment horizons, no change in interest rates results in no expected change in the annualized total return for the hypothetical investment.

Real-world examples

Figure 2: The difference duration made to total return in a rising rate environment
The first panel of the figure shows the total annualized return for the Bloomberg Barclays US 1-3 Year Treasury Index from July 2016 through October 2018 in a bar chart format. The first bar shows a price return of ‒1.54%, the second bar shows a coupon return of 1.56%, and the third bar shows a residual return contribution of 0.03%, which sums up to a total return of 0.05%.    The second panel of the figure shows the total annualized return for the Bloomberg Barclays US Long Treasury Treasury Index for the same period in a bar chart format. The first bar shows a price return of ‒8.16%, the second bar shows a coupon return of 2.61%, and the third bar shows a residual return contribution of 0.28%. which sums up to a total return of ‒5.27%.
Figure 3: Larger rises in rates resulted in greater increases in coupon payments for short-term bonds
The first panel of the figure shows the total annualized return for the Bloomberg Barclays US 1-3 Year Treasury Index from July 2016 through October 2018 in a bar chart format. The first bar shows a price return of ‒1.54%, the second bar shows a coupon return of 1.56%, and the third bar shows a residual return contribution of 0.03%, which sums up to a total return of 0.05%.    The second panel of the figure shows the total annualized return for the Bloomberg Barclays US Long Treasury Treasury Index for the same period in a bar chart format. The first bar shows a price return of ‒8.16%, the second bar shows a coupon return of 2.61%, and the third bar shows a residual return contribution of 0.28%. which sums up to a total return of ‒5.27%.

The yield curve matters, too

Figure 4: Yields rose between May 2003 and May 2007, but not in parallel across the curve
One line shows the U.S. Treasury yield curve on May 2003. Yields for maturities up to 1 year are near 1%, and they increase toward 3% for maturities of 5 years and about 5% for maturities of 20 years.   Another line shows the U.S. Treasury yield curve on May 2007. Shorter-term yields are much higher than they were 5 years earlier. Yields for maturities up to 1 year on this yield curve are near 5%. They fall slightly for yields of maturities roughly between 3 and 10 year, before returning to about 5% for maturities of 20 years. The 20-year level is very similar to that of 5 years earlier.

Investors should focus on what is within their control

Contributors

Ian Kresnak's headshot
Vanguard logo

Vanguard is the trusted name in investing. Since our founding in 1975, we've put investors first.