Chris Farrell: A fundamental shift in interest rates is taking hold

There is no doubt that one of the great bull markets in history is over.

The bond market has shown remarkable long-term performance, with yields falling from over 15% to around 1% over the past four decades.

Yet, the surge in inflation to 8.6% over the past 12 months has ended the era of low interest rates. The sharp hike in the benchmark interest rate by the Federal Reserve on June 15 is a punctuation mark of the new rate regime.

What are the implications for bond investors?

Bonds don’t do well when inflation is rising. The calculation is inexorable. When interest rates rise, bond prices fall.

For example, suppose you hold a US Treasury bond with a fixed payment of 2%. Market interest rates increase to 3%. If you try to sell your treasury bill, its price must drop because it competes with investors who can buy a similar security yielding 3%. Even if you don’t sell, the price of your bond will adjust to the new rate environment. You will show a loss of paper.

That said, investors shouldn’t fear rising rates, assuming you don’t need the money right away. The math finally starts to work in your favor.

Fixed income investors benefit from higher interest rates as they reinvest their money at newly available higher yields. Most people hold fixed income investments in mutual funds, for example, in their retirement savings plan. In this case, you are probably reinvesting the dividends and your fund is buying new fixed income securities at higher rates.

Higher rates are also welcome for savers who want to put household money in easily accessible interest-earning places like online savings accounts and certificates of deposit.

A reader asked me if “people interested in CDs for relatively short-term money should enter into six- to 24-month contracts now or wait for interest rates to rise?”

No one knows when rates will peak. A classic way to manage uncertainty is to “ladder” your CDs with different maturities and, therefore, different interest rates.

You can buy CDs with three-month, six-month, one-year, and 24-month contracts — or a combination of terms. If rates rise further, your short-term CDs will mature quickly and you can reinvest in new CDs at higher rates.

If rates peak soon and start falling, you still earn a better return on your longer-term CDs.

Farrell is a business contributor to the Star Tribune, Minnesota Public Radio, and American Public Media’s Marketplace.

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