When will we feel the benefit of higher interest rates?

One of my favorite long-time readers and clients asked me a good question last week, which was:

As I recall, David, you said that eventually, higher interest rates would be a benefit. If my recollection is correct, when will that be?

It’s such a great question, and I thought I would answer it for everyone, but unfortunately, my answer is a little mealy-mouthed: it depends.

It depends on how high interest rates go—not the part of the yield curve the Fed controls, which probably isn’t going much higher. It depends on where the yield on Barclay’s aggregate goes. At the start of the year, it was about 4.5 percent, and now it’s closer to 5.0 percent.

The benefit of higher interest rates is that we earn more interest. This seems obvious when you say it, but it doesn’t feel obvious when we look at our accounts because bonds are down slightly halfway through the year.

To illustrate, I decomposed the return for the Bloomberg Aggregate over the last ten years or so into price change and interest earned.

The green bar shows the interest you received. Importantly, I DID cheat in 2024, which I labeled as 2024P for partial since the year isn’t over. The cheat is that I took the interest received so far this year and doubled it since we’re only halfway through the year. That won’t be precisely accurate, but it will be in the ballpark.

Notice how it was never above three percent until 2023, after rates started to rise. Now it’s over five percent (again, with my cheat). That’s the benefit that I was talking about.

The yellow shows the price change, and you can see that in 2015 and 2016, there was no price change – the total return (in the orange diamond) is equal to the interest.

In 2017, yields fell a little, pushing the price slightly. In 2018, the opposite happened, so the price offset the interest. In 2019 and 2020, yields cratered, and the price change was a big part of the return.

In 2021 and 2022, the prices fell so dramatically that I clipped the chart because it made the green part hard to read. I’m not hiding anything from you because you lived it!

Last year, rates fell, so you got three percent in income for the first time in this period, and there was a bump in prices. This year, even though the interest is still higher (but not fully realized as mentioned), it’s offset by the lower price (to calculate the orange dot, I took the actual interest earned so far this year, not what we ‘should’ get by year-end).

So, if rates are steady and the yellow bar goes away, like in 2015 and 2016, you’ll be better off because the interest is higher. If rates increase, the price will hurt but give us more interest later. If rates fall, we’ll be happy about the price change but unhappy with the lower yield.

I hadn’t thought to show it this way, and I like it because it shows how steady the interest is and how it’s growing finally. It also shows that the price is volatile, and that’s because rates are jumping around. It’s a bit like the stock market – ignore the price machinations and focus on the increase in fundamental value.

When my client read my explanation, he summed it up nicely: If higher rates last long enough, it will be a benefit and outweigh the price losses.

Exactly, it will take time, but as I started saying more than five years ago, as long as your time horizon is longer than your bond portfolio duration, you want rates to go higher. It’s been a painful process, but higher rates are better over the long run.