How to Invest for Higher Rates
Interest rates declined from 1981 until 2020, but we may now be in a long-term trend in the opposite direction. Here's how investors can prepare.
Bonds are tempting. The yield on a 10-year Treasury note has increased by a factor of eight in just six years. Do you want to own stocks, which for the past hundred years or so have returned an annual average of 10%, or do you want to own a 30-year bond that was recently yielding 5.3%?
Of course, stocks have returned more on average, but they’re wildly uneven. Since 2000, the S&P 500 Index has returned less than 5% in nine calendar years — including six that were money-losing (one of them down 37%). By contrast, when you buy a Treasury, you're guaranteed to get paid its face value at maturity.
I am a big advocate of stocks for the long run. But the choice isn't binary. Investors can own both — and now they should.
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Bond interest rates had been in long-term decline from September 1981, when 10-year notes were yielding 16%, until the summer of 2020, when they dropped below 1%. Rates bounced back after COVID, and since then the direction has been upward. We may be in a new long-term trend in the opposite direction.
It's not hard to understand why. If you own a bond, you want to get repaid in dollars that haven't lost a lot of their value to inflation. But we're now in a period in which inflation seems intractable. Even at 3%, inflation reduces the buying power of $100 to $74 in 10 years. Under such conditions, if you lend money (and that's what you do when you buy a bond), you naturally want a strong yield as compensation.
Then, consider demand. Everyone seems to be lusting to borrow. From 1947 through 2008, the U.S. government ran a deficit of more than 5% of gross domestic product (GDP) exactly once.
Since 2009, there have been 11 such deficits, and the gross federal debt exceeded $40 trillion in August, up from $6 trillion in 2000. Interest on the debt amounts to more than yearly defense spending and accounts for half the annual deficit.
Meanwhile, the giant technology companies that were paltry borrowers in the past are now taking on loads of debt, mainly to pay for data centers. Together, Amazon (AMZN), Alphabet (GOOGL), Oracle (ORCL) and Meta Platforms (META) issued $194 billion worth of bonds in 2026 through July 7, according to an accounting from Reuters, compared with $108 billion for the same period last year.
With all that competition for their money, lenders demand higher interest rates, which in turn means pricier mortgages — which means political trouble. The Treasury secretary said he would buy up America's own long-term debt as a way to reduce interest rates, but that's the kind of desperately clever act that can have the opposite effect.
At the same time, the dividend yield on the average S&P 500 stock has dropped to 1.1% — or 3.7 percentage points below the recent yield on a 10-year Treasury. If you like income, bonds have become exceptionally attractive.
A giant caveat to rising interest rates
But there's a problem. If rates keep rising, as I suspect they will, then the value of a bond you own today will fall. Consider: You buy a 10-year Treasury when it’s issued at 5%. A few years later, the interest rate on a new Treasury rises to 7%.
No one is going to buy your lower-yielding debt at its price when issued. To sell it, you will have to accept a large discount. Of course, you can hold your note to maturity and get full face value at the end of 10 years, but during that time, you are stuck getting interest that's lower than market.
For example, a 10-year Treasury issued in August 2021 with a coupon (stated original interest) of 1.25% and maturing in 2031 was recently trading at around $85 per $100 face value, a discount of 15% from the issuing price. The longer the maturity, the bigger the discount. A 30-year bond issued in 2021 at 2% is trading at $53 — a 47% discount. Ouch.
There are ways to avoid this risk. One is to create a ladder for your bonds. For example, rather than buying one note maturing in 10 years, you can buy five notes, maturing every two years. When the shortest note matures, you take the proceeds and buy a new 10-year note. If rates have risen, the new note will yield more than the one you first purchased.
A simpler approach is to buy shorter-term Treasuries now and wait until rates rise — if they do. The two-year Treasury note is currently yielding a juicy 4.3%.
Or purchase a fund such as Fidelity Short-Term Bond (FSHBX), which also owns corporate bonds. It has a yield of 4.5% and a duration of just 1.9 years. Duration is a term that indicates how much the price of a bond moves when interest rates change. In this case, if rates were to rise by one percentage point, the value of the fund’s portfolio would fall by roughly 1.9%. (Prices, yields and other data are as of August 31 or the latest available.)
Another way to mitigate risk is through buying longer-term bond funds, which themselves own debt of varying maturities. But beware of high expense ratios. One of my favorite choices is the Vanguard Intermediate-Term Bond ETF (BIV), an exchange-traded fund with an expense ratio of just 0.03%.
The fund has a yield of 5.0% and a portfolio split roughly 60-40 between Treasuries and corporates. All the bonds are investment grade — that is, rated BBB- or higher by Standard & Poor's. Roughly three-fifths of the portfolio is rated AAA or AA. The average maturity of the ETF's bonds is 7.3 years, and the average duration is six years.
If you want longer maturities, consider the iShares 20+ Year Treasury Bond ETF (TLT), an exchange-traded fund with an expense ratio of 0.15% and a recent yield of 4.9%. The fund owns only T-bonds, with an average maturity of 25.9 years and a duration of 14.9 years. This is a good time to lean toward Treasuries because the interest spread between bonds issued by corporations and bonds issued by the U.S. government is so low.
I also like iShares Agency Bond (AGZ), which owns AA-rated debt issued by government-sponsored enterprises such as Fannie Mae and Federal Farm Credit Banks, carrying slightly higher interest than straight Treasury bonds of comparable maturities.
Individual corporate issues are not on my wish list. Even the big tech companies are getting overextended as they compete to build their AI businesses. In a June newsletter, Pimco, one of the best bond specialists, warned, "The default cycle is reasserting itself, and … quality and credit selection will matter more than ever."
A big drawback of bonds is that they require more from an investor than stocks, for which you make a single decision: Do I want to be a partner in this company? Buying bonds means weighing such variables as credit risk, inflation and maturity — all affected by something unknowable, which is where interest rates are going, and when.
Still, this is a moment when bonds beckon irresistibly. Don't go overboard. But if you'd like to get returns of 5% from part of your portfolio, with assets that offer ballast in rough seas, well ... now may be the time.
James K. Glassman chairs Glassman Advisory, a public-affairs consulting firm. He does not write about his clients. His most recent book is Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence. He owns none of the securities listed here. You can reach him at JKGlassman@gmail.com.
Note: This item first appeared in Kiplinger Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.
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