With interest rates currently low you may be wondering how your bond fund will do if rates rise. You may also be looking into alternative fixed income investments such as I Bonds and EE bonds. In this post we explore a few scenarios of how it might play out.

By definition, bonds are debt obligations that various entities like corporations and governments issue. A special type of bond available to individual investors are EE Bonds and I Bonds backed by the US Treasury. These bonds have interesting built in perks that are worth considering.

When you purchase a bond, you lend your money to one of these entities for the set period (5 years, 10 years, etc). And in exchange, they pay interest on a regular basis, plus the face value of the bond at the end of its duration (maturity). Meanwhile, bond funds hold thousands of bonds with different durations, credit risk, interest rate and other features depending on the type of fund. The manager in charge of the fund will buy or sell them according to the fund’s prospectus. The fund itself trades at its ‘net asset value’ which is the current market value of all the bonds added together. But how do you know which is better if interest rates change? Here is a comparison of their returns under various circumstances.
 

1) Rates Stay Below 2% for 20 Years

For the first scenario we'll consider what would happen if rates stay below 2% for the next 20 years. 

It is clear that EE bonds win if interest rates stay below 2% for the next 20 years. But how did the EE Bond get the 3.5% return? That is because EE Bonds are guaranteed to double after holding them for 20-years. For more on EE Bonds see our post EE and I Bonds - worth a look.

* With the Bond Fund held in taxable, we assume the rate was 0.5% less than what you could get by holding it in a tax deferred account which is why we are showing zero taxable income here. In reality the rate would be 2%, but then there would be taxes annually that would create a net drag on the return. See more below about the assumptions that went into all this...
 

2) Rates Stay Between 2% and 3.5% for 20 Years

For the second scenario, we will consider what it might look like if rates fluctuate between 2% and 3.5% for the next 20 years: 

Although the Bond Funds take the lead in this case, the net results are almost a wash. If rates rise, most investors would probably break and re-purchase their I Bonds to increase the base rate and their overall yield. Holding bonds in the tax deferred account is the winner here.
 

3) Rates Rise To 5% Within 3 Years and Stay There for 17 More

For the second scenario, we will consider what it might look like if rates spike to 5% and then level off.

This scenario is tricky because if rates go to 5% quickly it would probably make sense to break the EE bond for a higher rate. But unfortunately, your overall return will suffer by the end of 20 years.

While the bond fund NAV would drop painfully in the short term, it would recover within a few years as the fund replaces the expiring lower yield bonds with new higher yielding bonds. Based on the above bond funds held in tax deferred accounts win this round as well.
 

4) Rates Slowly Rise to 5% Over 15 Years and Stay for 5 More

Lastly, we will consider a slow rise in rate up to 5% within 15 years. It will then stay constant until the end of the term. Let us see what the net value for each of the cases in the overall period of 20 years would be:

Yet again, bonds held in tax deferred accounts win this round. In this final scenario it would probably make sense to hold onto the EE bond to get the 3.5% return after 20 years rather than break it late in the game to get a higher yield, forfeiting many years of 3.5% compounding.
 

5) How Stocks Fare, Depending On Location (Taxable Vs IRA Vs Roth): A Comparison

Finally, for fun we compare how stock funds do, depending on the location. This has nothing to do with interest rates. We went with a 7.5% return for stocks (with the 0.5% penalty in the taxable account for this tax drag). This helps illustrate how powerful tax deferred accounts can be. Since the appreciation in the stock funds is expected to be high over 20 years, we accounted for long term capital gains tax as well.

Compared to what the bond funds are doing above, these returns are WAY higher and the ROTH account wins handily. Of course there are more risks and volatility in stocks compared to owning bonds. The long term capital gains tax applied to the stock appreciation held in the taxable account definitely hurts.
 

Assumptions For All The Scenarios

First off, the math in determining “what could happen with bond returns” requires taking into account a lot of variables. We’ve tried to model a common scenario below - a middle aged couple looking to retire in about 20 years.

1. In the case of bond funds, we have assumed all dividends are automatically reinvested in the fund. We have also assumed that twenty years from now, the NAV of the funds will roughly be the same. This is a big IF, but changes in NAV should be a wash in the long run.
   1. In case of a rise in interest rates, the short-term value of the fund would drop (in theory). Alternatively, if rates drop, the value of the fund could increase.
   2. If the NAV does change it would trigger a tax loss or tax gain (in taxable accounts) which essentially creates a reversion to the mean in actual return, reducing the effect.
2. With inflation in check, I Bonds will provide a maximum yield of 2.5% (in other words even if rates are 5%, I Bonds won’t make it that high).
3. Given the tax drag applicable on dividends, a taxable bond fund held in a taxable account would earn 0.5% less than if held in a tax deferred account.
4. Since IRA / 401(k) contributions are pre-tax money, we adjust the initial balance up by $2,500 to make the starting balances equivalent.
5. Tax rate assumptions on a “married filing jointly” couple with income up to $80k:
   1. 22% income tax rate in 20 years, given 12% fed, 10% state.
   2. 12% of income tax rate in 20 years, for fed only
6. The bond / bond fund is sold in year 20 and withdrawn from the account, so the comparison is in after tax dollars.
    

Tax Notes

1. EE Bonds: These will be taxed as income on gains in the year of withdrawal. However, they are exempted from state and local income taxes.
2. I Bonds: These will also be taxed as income on gains in the year of withdrawal and are exempted from the state and local income taxes.
3. Bond ETF Taxable: These will be taxed on dividends as income. That is why the rate of return always runs a bit lower.
4. Bond ETF Tax-Deferred: These will be taxed on withdrawal of the entire amount.
5. Bond ETF Roth: These will already be taxed without any other extra tax.
    

Other Notes

• EE Bonds: A 3.5% return is guaranteed, but you must hold onto your investment for 20 years. In case the rates rise above 3.5% in the earlier phase of the 20-year term, it may not serve you well.
• I Bonds: These will give you a return that is protected from inflation, especially if you're worried about the chance of it in the next 10 years. Rate floor of 0%. Any other option beats them in every scenario, though. Possibly a good short-term play when CD rates are very low, but inflation is risking.
• Bond ETF Taxable: Return in a taxable account is the least because it includes 'tax drag' on annual dividends.
• Bond ETF Tax-Deferred: This is subject to RMDs.
• Bond ETF Roth: Maybe better to use Roth space for stocks?
   

Conclusion

Nobody knows for sure where rates are going. Following the comparisons mentioned above, it is ideal for you to weigh stocks in IRA / 401k or Roth accounts. They will certainly help you maximize your gains. However bonds also tend to do a bit better in tax deferred accounts. That hinges on having a lower tax rate in retirement though.

Secondly, you might want to hold onto your EE bonds and free up space in Roth / 401k for stocks instead. 

And finally, EE bonds will offer a nice net boost in states with a high-income tax.