Bonds are often viewed as a conservative, fixed investment and, when highly rated, appropriate for investors with low risk tolerance. But while bonds can definitely present lower market risks than stocks, that doesn’t mean they’re without any risk at all. One of the biggest risks that bondholders face is the one brought on by a rising interest rates. And with interest rates currently at record lows, the question is no longer if rates will go up, as we expect they will, but rather when they will go up.
Understanding the Fed Rate
The Federal Reserve sets the federal funds rate, which is the rate of interest financial institutions charge each other when lending money overnight. When this rate fluctuates, so do other interest rates such as prime rate. When the fed rate rises, the interest rate on new bonds (also called coupon rates) also rises in order to make them more attractive to investors.
When New Issue Rates Rise, Old Issues Lose Value
The essential concern when interest rates rise is that it makes existing bonds, like those currently sitting in an investment portfolio, lose value. The reason for this is that they have a lower yield than the new bonds being issued paying a higher interest rate. If you want to sell the bond to another investor, you’ll have to sell at a discount in order to make up for the lower coupon rate.
Example: If I bought a bond for $10,000 that pays 3% interest ($300 per year) and new bonds are being issued at 5% ($500 per year), no one would want to buy my bond for $10,000 and only earn $300 per year when they could buy a new bond for $10,000 and earn $500 per year. I would have to sell my bond for only $6000 so that the $300 per year that it pays would yield the same 5% being issued on new bonds ($300 is 5% of $6000). Therefore, my bond has declined in value from $10,000 to $6,000.
Managing Your Portfolio
There are a few ways you can try to manage your bond portfolio from rising interest rates:
- Consider how the overall return fits your income needs. If you focus the creation of your bond portfolio around generating the kind of income you need, then you may still be getting what you need from the portfolio even if it doesn’t have the most competitive interest rates.
- Consider alternative asset classes: There are a variety of other asset classes that provide a fixed-income like experience but may be less sensitive to moves in interest rates. Consider the risks associated with other types of asset classes, combined with your income needs and talk to your financial advisor to see what other asset classes may fit your needs.
- Diversify bond sectors: Just as with stocks, there are many different sectors in which you can buy bonds. You can look at investment-grade bonds, floating rate bonds, emerging markets, mortgage-backed bonds and more. In doing so, you expose yourself to many different returns, which can help cushion the blow of rising interest rates. Just keep in mind that diversifying a portfolio doesn’t guarantee a profit or protect against market losses. However, different types of bonds respond differently in a rising interest rate environment.
At Kramer Wealth Managers, we want to help you build the right portfolio for your income needs and risk tolerance. Contact us today to see how we can help you navigate a tricky bond market to stay on your WealthPath.
Alternative investments involve specific risks that may be greater than traditional investments including limited liquidity, tax considerations, incentive fee structures, potentially speculative investment strategies and may be offered only to clients who meet specific suitability requirements.
Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. An issuer may default on payment of the principal or interest of a bond. Bonds are also subject to other types of risks such as call, credit, liquidity, interest rate, and general market risks.