Thinking about a possible increase in interest rates in the future, does it make sense to invest in bonds?

Would the price of a bond fund holding mostly AAA rated Fannie/Freddie issues, and medium term US Treasury notes (such as AGG) be affected significantly by interest rate increases?

  • If we could predict the future and answer this question, we wouldn't waste that information by giving it away on stack exchange for free. – farnsy Feb 19 '15 at 7:14

That particular fund (AGG) doesn't have a long enough track record to see how it performs does during both rising and falling interest rate environments (it has just one instance of each in its history). It started in 2003, as interest rates were strong. It trended downward until the end of 2008, which is about the time interest rates in the USA stabilized at the bottom. Since then, as rates have been flat and the Fed has worked to provide liquidity in the debt markets, it's NAV has trended upward.

It is reasonable to expect, looking at its top 10 holdings, that the mid-range Treasury notes will hold their value a little better than a fund holding a higher percentage of longer-term issues. But there will likely not be much capital appreciation while rates are rising, or while the Fed is unwinding itself from the liquidity policies that have been in place. But you don't typically buy a bond fund for growth.

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  • True. I'm not expecting the fund to appreciate in value, I just don't want to buy it today at $110 and in three months see it plunge to $95. So, you estimate that because of its large mid-term asset allocation it won't experience such a drastic price drop? Am I worrying too much about it? – AxiomaticNexus Feb 19 '15 at 1:17
  • I would expect it's NAV to drop, but not as much as a fund that had more long-term notes in the portfolio. Yahoo! Finance reports its beta as 1.02, but doesn't make it easy to see what benchmark it's based on. The NAV trended down as interest rates trended up last time. I can only venture a guess that it would jump down if rates jumped up. – Kent A. Feb 19 '15 at 1:27

Yes, corporate and government bond prices will be affected significantly by interest rate changes.

To answer the question of whether it makes sense to invest in depends on whether you're willing to make a macro forecast based on a large number of factors, including what decisions you think the Fed will make in the future.

I approach the problem by admitting to myself that I cannot reliably predict where bond/equity/real-estate/etc markets will be in a few years. And I cannot accurately judge others' predictions as well.

Choose an asset allocation plan that will suit you during any period of boom or bust, and stick with it!

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