How Rising Interest Rates May Affect a Bond Portfolio

Alan Appelbaum

May 5, 2023

How Rising Interest Rates May Affect a Bond Portfolio

Rising interest rates may negatively affect a bond portfolio in the short run but can increase its return over the long run.

Muni bonds offer a haven when rates rise, which can help to offset portfolio losses and boost returns when stocks fall. However, rising rates can also lead to an investor’s muni portfolio losing value, so it’s important to be aware of the risks.

Increased Coupon Rates

As the Federal Reserve prepares to raise interest rates, many investors with muni bonds are concerned about how rising interest rates may affect their bonds. While some bondholders are selling their assets to prepare for the rate increase, others are looking for ways to protect their portfolios while maintaining exposure to fixed income.

Muni bonds are a unique type of bond that can be a valuable addition to an investor’s portfolio, particularly in a rate-raising environment. They offer several benefits that can help protect your portfolio, including lower volatility and tax advantages.

Credit Quality – Municipal bond issues generally have higher credit quality than private corporate bonds. Still, the issuer’s rating can change over time, so it’s important to consider this factor when purchasing a muni bond.

Tax Advantages: Muni bonds can benefit investors in high-tax brackets because they often pay interest payments exempt from local, state and federal taxes.

Increased Valuation

During rising interest rates, some investors may decide to sell bonds. However, this can be a risky strategy because it could result in the bonds’ value loss.

Another possibility is to purchase bonds at a higher rate than other investors are paying. This is called a premium bond and can protect your portfolio as interest rates rise.

Muni bond investors also benefit from their tax-exempt earnings, which helps reduce taxes on their income. The IRS considers the interest paid on muni bonds to be exempt from federal income tax and state and local taxes.

As the Federal Reserve raises interest rates, muni bonds will become more attractive for certain investors. In particular, those looking to extend their duration and lock in elevated yields for a multi-year period could find great value in munis. Historically, munis have outperformed taxable fixed income during significant rate hikes.

Increased Taxes

Municipal bonds are a popular way for high-income investors to manage their taxes. This is because the interest paid on munis is tax-exempt at the federal level and may be exempt from state and local income taxes if the investor lives there.

Nevertheless, the government has recently enacted several policies that could increase tax rates for people at all income levels. These include changes to the progressivity of individual income taxes and a proposed new tax on certain types of business income.

These policies, if implemented, would likely affect taxpayers’ behaviour in various ways. For instance, the increase in tax rates would likely reduce the value of many exclusions and deductions typically used largely by high-income households. They could also encourage people to shift their taxable income from one tax form to another or to use nontaxable or tax-deferred forms of income. Those effects could be significant.

Increased Risk

Rising interest rates have a major impact on bond prices and yields. When rates rise, investors naturally sell low-interest bonds in favour of higher-yielding ones. This creates downward pressure on bond prices, and higher yields often mean higher-quality bonds are more expensive.

However, muni bonds may be less susceptible to rising interest rates than fixed-income assets. This is because they historically have lower default rates than corporate bonds, but not all munis are risk-free.

Investors should consider duration, which measures a bond’s sensitivity to changing interest rates. For example, a bond with a duration of 4 years is roughly twice as sensitive to a rise in rates as one with a duration of 2.

Credit remains strong as state and local governments collect substantial revenue and reserve growth due to the economic recovery and federal stimulus packages. This support, combined with low supply and a steeper municipal yield curve, can provide strong total returns to investors.