This asset class got slammed last year because the Federal Reserve raised interest rates seven times. There’s a silver lining to interest rate increases, though – new bonds are paying higher income (yield).

In the case of bond funds, new bonds that enter the fund to replace older ones will generate higher yields. This higher income will, over time, offset the value lost from the interest rate increases.

The number of years it takes for the effects of interest rate increases (value decrease + yield increase) to neutralize each other is approximately equal to the fund’s duration. This is a gauge of interest rate sensitivity and is a common measure to use when comparing bonds. High-duration funds hold longer-term bonds and will be more sensitive to rate changes compared to short-duration funds.

Since we know bond prices move the opposite direction of interest rates, it prompts an interesting question:

If I know interest rates will increase, should I avoid bonds or switch to short-term/short-duration?

It’s a logical train of thought.

However, even if we “know” (think) the Federal Reserve is going to increase rates, their adjustments only directly affect the overnight lending rate.

The Fed doesn’t go down the list of different bond maturities and physically adjust the 1-year rate, the 5-year rate, the 10-year rate, etc. These other rates are based on the market prices for the bonds which are set by market forces of supply and demand.

And just like any market, it’s hard to predict exactly what will happen. Expectations about the economy, inflation, and future interest rate increases are already baked in to market prices!

An example of market dynamics: If 10 year bonds are desirable, more people will be buying than selling which drives up the price. This price increase reduces the yield. When the yield gets to a point that the market no longer finds attractive, buyers stop buying and equilibrium is reached.

Overnight Rate: Fed -> Rate

Other Rates: Market -> Price -> Yield (rate)