Investors commonly take the view that bonds are not a good investment in an environment where the central bank is expected to increase interest rates, but the decision may not always be that simple.

Most investors base their decision to sell on the relatively simple assumption that rising interest rates push down bond prices and vice versa. While the inverse relationship between bond prices and yields is mathematically correct, investors that sell out of bonds in favour of say, cash, may not always be making the wisest decision.

Firstly, not all bonds are fixed rate bonds, many have floating rates of interest and the price of these bonds may not fall if interest rates go up – in fact the yield on these securities increases which is a good thing for investors. Secondly, yield curves in a country may already be pricing in future interest rate rises, so if the central bank raises rates more slowly than predicted by the bond market, possibly due to inflation being lower than expected, then the price of those bonds may go up.

Thirdly, if rates increase slowly in an environment where yields are higher the longer the term to maturity (i.e. an upwardly shaped yield curve), negative returns from decline in the price of the bond are, to an extent, reduced by the roll down the yield curve (i.e. the bond moves closer to its maturity date and yields for shorter-dated bonds are lower than for longer-dated bonds) so that returns remain positive overall even though interest rates may have risen.

Another factor to consider, when looking at a diversified portfolio of bonds is that the portfolio contains bonds of different maturities so that as yields rise, cash from coupons and from the maturing bonds can be reinvested in bonds that have a higher yield, resulting in higher returns going forward.

This point is illustrated by studying the Bloomberg (previously UBS) Composite Bond Index in Australia in 1994 and subsequent years. Although the RBA increased interest rates rapidly from 4.75% to 7.50% per annum in late 1994 and the Bloomberg Composite Bond Index lost 6.5% over a six month period, the index posted returns of 9.8% in the first half of 1995 and in the three years following 1994 the index returned 12.7% per annum.

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• JB Were Market Insights 13 April (PDF, 661KB)