For much of the past two years, investors have been asking the same question: When will interest rates come down? This month, the conversation changed.
On September 16, the U.S. Federal Reserve raised its benchmark interest rate by 0.25%, its first increase in more than three years. The move came as inflation remained elevated, prompting the Fed to once again use higher interest rates to help bring inflation toward its 2% target. For investors, a change in interest rate direction can feel unsettling. But it is worth remembering that interest rate cycles are just that, cycles. They change, and investment markets adjust with them.
Why Higher Rates Can Hurt Before They Help
The immediate impact of higher interest rates is not always pleasant for bond investors. When newly issued bonds begin offering higher yields, existing bonds paying lower rates become less attractive by comparison. Their market prices therefore tend to fall. For a bond fund, where the underlying investments are valued at current market prices, this can result in a lower NAV.
But there is another side to the story. As bond prices fall and yields rise, investment managers have the opportunity to purchase securities at more attractive prices and potentially lock in higher income for the portfolio. In other words, the same market conditions that can negatively affect today’s valuation can help create tomorrow’s return opportunities.
We Have Seen This Movie Before
The rapid increase in global interest rates during 2022 was particularly difficult for bond investors. After years of relatively low rates, central banks moved aggressively to combat inflation, causing bond prices to decline sharply.
At the time, it was understandably uncomfortable for investors to watch the value of their portfolios fall. But something else was happening beneath the surface. Bonds that had previously offered relatively modest yields were being replaced or supplemented with securities available at considerably more attractive yields.
As the market eventually stabilised, investors were not simply waiting for prices to recover. They were holding portfolios that had been given the opportunity to earn higher levels of income.
Markets Rarely Move in Straight Lines
It is tempting to divide market developments neatly into “good news” and “bad news.” Falling interest rates are good for bonds; rising rates are bad. Investing is rarely that simple.
Falling rates can increase the value of bonds already held in a portfolio, but they can also make it more difficult to reinvest maturing funds at attractive yields. Rising rates can depress current bond prices, but they can simultaneously create better opportunities for new investment. Every environment brings both challenges and opportunities.
The Federal Reserve’s latest projections suggest that rates could move somewhat higher before the end of 2026, although the path remains uncertain. Its September projections show a median year-end federal funds rate of 4.1%, compared with the current target range of 3.75%–4.00%.
Markets will continue to adjust as expectations change. So, for investors, perhaps the question is not, “What will interest rates do next?” The better question should be: “Is my portfolio positioned to navigate different interest-rate environments?” Because over a long investment horizon, there will almost certainly be more than one.
Toni-Ann Neita-Elliott, CFP is the Vice President, Sales & Marketing at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm
Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm