Prudential Investment

HOW DO INTEREST RATE CHANGES AFFECT BOND INVESTMENTS?

Total return is comprised of yield (the bond's coupon payment) plus market movements...

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WHAT FACTORS INFLUENCE U.S. INTEREST RATES?

In general, changes in short-term interest rates have a greater impact on short-term...

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WHERE ARE LONG-TERM U.S. INTEREST RATES HEADED?

Predicting the future path of interest rates is difficult because they are influenced by...

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WHAT ASSET CLASSES PERFORMED WELL DURING RISING RATE PERIODS?

Certain types of investments have delivered strong historical returns during rising rate periods...

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INTEREST RATES AND BOND PRICES ARE INVERSELY RELATED

Historically, bond prices and interest rates move in opposite directions. This happens because as interest rates rise, newly issued bonds carry a higher coupon than previously issued bonds, causing prices of older bonds to drop as they become relatively less attractive to investors. Conversely, older bonds become relatively more attractive than newer bonds issued after interest rates decline.

Represents conceptual depiction of bond price and interest rate relationship. For illustrative purposes only.

  • +How do interest rate changes affect bond investments?
    • Total return is comprised of yield (the bond's coupon payment) plus market movements (the bond price increase or decrease). The following examples show how the movement of interest rates affects a bond portfolio's returns.

    • +How does the magnitude of interest-rate movements affect a bond's total return?

      The greater the magnitude of change in interest rates, the larger the impact to a bond's price. The example below illustrates the impact of a 1% increase versus a 2% increase in interest rates for a hypothetical Bond XYZ.

    • +How does a bond's maturity affect its interest rate risk?

      Longer maturity bonds are more sensitive to interest rate risk than shorter maturity bonds because they have a longer time before the principal is paid back to the investor.

    • +How does a bond's coupon rate affect its interest rate risk?

      Lower coupon bonds have greater interest rate risk than higher coupon bonds with the same maturity because they have a lower yield cushion meaning they have a smaller percentage of total cash flows that come from income payments.

  • +What factors influence U.S. interest rates?
    • In general, changes in short-term interest rates have a greater impact on short-term bonds and changes in long-term interest rates have more impact on long-term bonds.

      Short-Term Rates

      In the U.S., short-term interest rates are strongly influenced by the Federal Reserve, which was created by Congress to provide a flexible and stable financial system. The Federal Reserve implements monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices. During a period of slowing economic growth, the Federal Reserve may decide to lower short-term interest rates (Fed Funds Rate) to help stimulate the economy. The Federal Reserve may decide to raise short-term rates in an effort to slow down the economy, which may be growing too fast and result in high inflation.

      Long-Term Rates

      Long-term interest rates are primarily influenced by long-term expectations for U.S. economic growth and inflation. They may also be affected by current long-term global market rates.

      Do short- and long-term interest rates always move in the same direction and by the same magnitude?

      Short- and long-term interest rates are influenced by different factors and as a result they may not always move in tandem. Consider three possible rising rate scenarios:

      Source: PGIM Investments. These three scenarios represent conceptual depictions of future potential movement of short-term and long-term U.S. interest rates. For illustrative purposes only.


       

      How do global interest rates influence U.S. interest rates?

      While U.S. short-term interest rates are strongly influenced by Federal Reserve monetary policy, long-term U.S. interest rates are affected by what is happening outside the U.S.

      U.S. long-term rates are currently well above other developed market interest rates, leading many market participants to conclude that, even if U.S. long-term rates move higher, there are limits as to how much they can diverge from the current low rate global landscape


       

       

      Short-term rates don't move since the Federal Reserve is not making adjustments to monetary policy. Long-term rates are rising as the market anticipates an increase in economic growth and inflation.

       

      Short-term rates rise as the Federal Reserve tightens monetary policy to help slow a growing economy. Long-term rates are not moving as the market does not anticipate a substantial increase in economic growth or inflation.
  • +Where are long-term U.S. interest rates headed?

    Predicting the future path of interest rates is difficult because they are influenced by many factors, including Federal Reserve policies, economic sentiment, foreign central bank policies, and geopolitical events. There are many different ways rates can go in the coming years.

  • + What asset classes performed well during rising rate periods?

    How often do interest rates rise?

    Over the last 20 years, there have been eight periods where the 10-Year U.S. Treasury Yield rose by 75 basis points or more (a basis point is 1/100 of a percent)

    As rates rise, certain asset classes have historically outperformed

    Investments such as Global Real Estate, Master Limited Partnerships, High Yield Bonds, Short Duration Municipal Bonds, and Short-Term Corporate Bonds have delivered strong historical returns during rising rate periods.
    These investments tend to perform in line with the business cycle. As the economy grows or experiences higher inflation, these investments have outperformed more conservative investments like U.S. Government Bonds.


    4Source: Morningstar Direct as of 12/31/14. Calculated by PGIM Investments LLC using data presented in Morningstar software products. All rights reserved. Used with permission. Rising interest rate periods are defined by the monthly movement of the 10-Year Treasury Yield, using a threshold of 75+ basis points or greater. The 10-Year Treasury Yield is a commonly used reference point for tracking the general movement of U.S. interest rates. The decision to use a 75+ basis point threshold to define a rising rate period was done so that an investor could see multiple instances of rising rate periods to better assess how different asset classes performed during these types of periods. 5Source: Morningstar Direct as of 12/31/14. Calculated by PGIM Investments LLC using data presented in Morningstar software products. All rights reserved. Used with permission. All indices are unmanaged. An investment cannot be made in an index. Please see page 10 for asset class breakdowns and corresponding indices.

SUMMARY

One can argue that interest rates can rise, fall, or remain flat.

What cannot be argued is the inclusion of fixed income and the potential benefits of a fully diversified fixed income portfolio.

Understanding how bond prices are affected by changes in interest rates and what factors make a portfolio more or less sensitive to changes in rates
can help you build a portfolio that can minimize interest rate risk.

Seek professional guidance

While mutual funds can generally be purchased directly, we believe every investor can benefit from the expertise and services of a financial professional who knows you and understands your goals, reasons for investing, and the amount of risk you're comfortable assuming.

 

0284322-00002-00 Ed. 06/2017