With Interest Rates Up, Why are Bond Returns Down?

The bond market continues to be one of the most misunderstood parts of the financial world. The latest confusion comes from the effects that rising interest rates have had on the returns of funds and accounts that invest in bonds. If interest rates are rising and bonds earn money from the yield, or interest, paid on them, why were bond returns for 2005 generally lower than those for 2004?

Higher interest rates have reduced returns in the U.S. bond market
During 2005 interest rates rose, resulting in lower returns for the Lehman Brothers U.S. Aggregate Index, which measures the return of investment-grade bonds in the United States. For the year, the CREF Bond Market Account returned 2.25%, substantially less than its 4.17% return during 2004, but in line with the decline of its benchmark, the Lehman index, which fell from 4.34% to 2.43%. To see why this happened, it's necessary to understand how bonds work as investment vehicles.

Bond prices and bond yields move in opposite directions
Bonds are traded in the financial marketplace five days a week, just like shares of stock. While bonds have a face value, known as "par," the prices at which they trade in the market fluctuate freely. When a bond is sold at a price below par, its yield goes up. When a bond is sold above par, its yield goes down.

Bond prices are determined in part by the yield that bond buyers are willing to accept, based largely on their expectations about future rates of inflation. Prices are also affected by short-term interest rates, which are set by the Federal Reserve.

What happened in the bond market last year?
The Federal Reserve Board raised the federal funds rate eight times during 2005, from 2.25% to 4.25%. This is the rate that banks charge each other for overnight loans, and it affects many short-term rates, from the money market to short-term Treasury securities.

Increases in short-term interest rates generally cause longer-term rates to go up, too. If bond investors can receive more than 4% for a two-year Treasury security, as they were able to during late 2005, they will usually demand a substantially higher yield for the ten-year Treasury note, which is the benchmark for the bond market.

Responding to higher short-term interest rates, the yield on 10-year Treasuries increased from 4.22% on January 1, 2005 to 4.39% at the end of December 2005. Since bond yields and bond prices move in opposite directions, the prices of 10-year Treasuries, and of many other long-term bonds, fell during 2005 as yields increased.

The good news for bond investors is that, while short-term yields rose sharply, increases in long-term yields were much more modest.

How did bond prices affect bond returns?
A decline in bond prices is registered by bond portfolios daily because their holdings are revalued each day the bond markets are open. (This process is reversed when interest rates drop and prices rise, which is why the CREF Bond Market Account posted a 10.08% return in 2002, when interest rates declined.)

If bond returns came only from changes in bond prices, bond accounts like the CREF Bond Market Account would have suffered losses during 2005 as bond prices fell.  But the return from a bond account is derived from two sources. The second contributor to the account's return is income--the interest payments on the portfolio's bond holdings.

In 2005 interest payments more than offset the decline in bond prices, allowing the account to post a positive return. In fact, the account significantly outperformed the Dow Industrial Average, which lost 0.61% during the year.

How did these changes affect the CREF Inflation-Linked Bond Account?
The CREF Inflation-Linked Bond Account invests in the inflation-protected securities issued by the U.S. Treasury. The interest on these bonds is calculated by adjusting each bond's principal amount according to the Consumer Price Index. If the CPI goes up, the principal amount is adjusted upwards, producing a higher interest payment.

However, like other bonds, these bonds are traded in the marketplace. As a result, their yields and prices fluctuate. During 2005, inflation-protected securities were affected by rising interest rates, which led investors to demand higher yields, resulting in lower prices for these bonds. After factoring in expenses, the 2.53% return of the Inflation-Linked Bond Account was in line with the 2.84% return of the Lehman Brothers U.S. TIPS Index.