Bridge over ocean
1 March 1985 Financial Analysts Journal Volume 41, Issue 2

Rethinking our Thinking about Interest Rates

  1. Richard W. McEnally

Fixed income portfolios are suppliers of capital. As such, they gain when the price of capital—the interest rate—increases. Unfortunately, they also lose when rates increase, because the value of existing portfolio assets declines. Although attention has commonly focused on the loss in present value, rather than the gain from the reinvestment opportunity created by higher interest rates, in reality the gain will dominate the loss when the portfolio’s investment horizon exceeds the portfolio’s duration.

Interest rate increases thus represent favorable developments for many portfolios, including those for IRA accounts, pension funds and life insurance companies. To evaluate properly the condition of these portfolios, it is necessary to utilize estimates of future portfolio value that explicitly incorporate forecasts of future reinvestment rates. In given interest rate environments, however, it is still appropriate to use short-term total returns to evaluate portfolio performance.

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