There's no doubt that one of the great bull markets in history is over.
The bond market put on a striking long-term performance with yields falling from more than 15% to around 1% over the past four decades.
Yet the surge in inflation to 8.6% over the past 12 months put an end to the era of low interest rates. The Federal Reserve's sharp hike of the benchmark interest rate on June 15 is a punctuation mark to the new rate regime.
What are some implications for bond investors?
Bonds don't do well when inflation is climbing higher. The math is inexorable. When interest rates rise, bond prices fall.
For example, let's say you own a U.S. Treasury with a fixed payout of 2%. Market interest rates rise to 3%. If you tried to sell your Treasury bond, its price must fall since it's competing for investors that can buy a similar security yielding 3%. Even if you don't sell, your bond price will adjust to the new rate environment. You'll show a paper loss.
That said, investors shouldn't fear the rise in rates, assuming you don't need money immediately. The math eventually starts working in your favor.
Fixed income investors benefit from higher interest rates as they reinvest their money at newly available higher yields. Most people own fixed income investments through mutual funds, say, in their retirement savings plan. In that case, you're probably reinvesting the dividends and your fund is buying new fixed income securities at higher rates.
Higher rates are also welcome for savers who want to put household money into easily accessible interest-earning places, like online savings accounts and certificates of deposit.
A reader asked me whether "people interested in CDs for relatively short-term cash should lock into six-to-24-month contracts now or wait until interest rates rise?"
No one knows when rates will peak. A classic way to deal with the uncertainty is to "ladder" your CDs with different maturities and, therefore, different interest rates.
You could buy some CDs with three-month, six-month, one-year and 24-month contracts — or some combination of maturities. If rates rise further, your short-term CDs will mature quickly and you can reinvest in new CDs at higher rates.
If rates peak soon and start to come down, you're still earning a better return on your longer-term CDs.
Farrell is economics contributor to the Star Tribune, Minnesota Public Radio and American Public Media's "Marketplace."
