If  and when interest rates rise, how will that affect my investments?

That’s the question investors have been asking themselves for years now – nearly a decade – and the main reason many still shun long-term bonds. We’ve been saying interest rate fears are overblown for about as long.

This rate worry, along with the equally irrational fear of total economic collapse, is also why some investors favor cash, gold, commodities, high-fee hedge funds, high-commission annuities, junk bonds,  floating-rate bonds and multiple “alternative” investments too numerous to list here. 

Yet as a group those investments have largely underperformed simple zero-risk, inflation-linked savings bonds you can buy directly from Uncle Sam. 

For some reason, investor fear of rising interest rates gets more press than the brewing tech bubble. Maybe it’s the risk/reward comparison that scares investors. Sure, it won’t be good for Alibaba (BABA) investors coming in at a quarter trillion dollar market cap if earnings growth stagnates,  or Netflix (NFLX) investors buying at ~100 P/E ratios, but those companies could have more than the 3-4% annual gain longer-term investment-grade bond buyers can look forward to if things go well. 

If the tech bubble collapses, at least it was fun while it lasted. Why should investors risk investing in a high-downside long-term bond market when they barely make any money on the upside, anyway?

Although it’s true that bonds have virtually no chance of beating the stock market as a whole over the next 10-20 years, and are unlikely to deliver more than, say, 5% average annual returns over the next decade, the downside fears are greatly overblown.

The key assumption by the rate-a-phobes is that inflation will eventually take off and interest rates will follow. Some actually fear that the Federal Reserve will eventually stop buying long-term bonds and artificially keeping short-term rates down altogether, which will send rates way up.

Let’s dispel that last fear. Of course, anything is possible in the short run once panic sets in, but without a sustained rise in inflation from its current sub-2% levels, we’re not going to see safe investment grade bonds pay, say, 6% or more for very long. 

That’s because you’re not going to get 4% “real” inflation-adjusted returns in a world with so much money ready to invest for income or safety (Yes, Baby Boomers, I’m talking to you). The world would be lining up to buy 6% government bonds. Maybe not during an acute short-term panic, but soon after.

Could inflation tick up to 4% and stay there long enough to send interest rates to 5 %?

Sure. 

But might inflation simply stay where it is, or even head to zero (or go negative, as it has in Japan)?

Yes. 

A more unexpected scenario – yet equally, if not more likely to happen – is that inflation could go up while interest rates remain below inflation. There’s no law that says you can’t have 4% inflation and 3% long-term bonds. Investors enjoy no inalienable right to positive inflation-adjusted returns. For years now, shorter-term bonds have had negative real returns – even at today’s low inflation levels.

True, it wouldn’t be pretty for longer-term bond mutual funds in the short term if interest rates were to rise. One of our long-term bond choices, Vanguard Long-Term Bond ETF (BLV), now yielding about 4%, could fall about 15% for every 1% increase in longer-term rates. 

So if this fund began yielding 6%, and not 4% after a swift run-up in rates, you could expect to lose 30%. 

Yikes. 

But you’d earn most of that back within a few years at 6%. Another way to look at it is this: BLV has generated more in returns to investors during the period investors have been hoarding low-duration bonds yielding less than 1% than it could fall in a rising rate environment. 

But we’re more concerned about what could happen to other non-bond investments if and when rates go up.

The stock market yields a bit less than 2% (even less for smaller cap stocks). While dividends grow with inflation, in theory, investors should want higher stock dividend yields if they went from 2.5% to 5% yields on government bonds. Doubling the yield on stocks to near 4% would require a 50% fall in the market – Dow 8,500-ish. 

Again, not that it would happen, as investors could expect inflation to boost dividend yields over time, but it certainly could happen. Since some of the earnings growth in recent years has come in the form of savings on interest rates, we could see earnings growth slow with higher interest rates. 

Factor in earnings problems for banks and financials, as well as falling sales for large ticket items like cars that rely on low-interest financing, and it’s certainly possible the stock market could fall more than long-term bonds with a sharp rise in rates – in fact, more likely than not.

Assets are priced relative to interest rates. 

As we’ve pointed out before, homes can behave like long-term bonds, priced off of the monthly payment of thirty-year fixed-rate mortgages. If mortgages went from 4% to 6% today, you could expect a 20%+ drop in your home’s value.

For the record, BLV has $870 million in assets. If you include all open-end share classes at Vanguard, that figure climbs to $7.2 billion. Vanguard Short-Term Bond ETF (BSV), which yields just under 1%, has $14.7 billion in assets, $36.8 billion, including all classes – 5x as much. Our expectation, as always, is for the popular choice to underperform the less popular option in the longer run.

So while we don’t expect any major interest rate increases, if they do happen, much of what’s considered a safe haven from rising interest rates might fall harder than long-term bonds, the very asset class considered most susceptible to a rate spike. 

Many investors are convinced they’ll lose tons of money in bonds when rates rise, but equally certain other strategies will prevent those losses. They’re probably wrong on both counts.