What to Do With Bonds When Interest Rates Rise
The Federal Reserve is close to raising interest rates again – perhaps even this year. This means your bonds will lose value, so what should a balanced investment portfolio do? Here are three things you can do to counter the impact of interest rates on your investments.
Relationship between bonds and interest rates
As we mentioned earlier , when interest rates rise, the value of bond funds falls.
When you invest in a bond, you need to think about two monetary values. First, the bond pays a fixed amount of interest on a quarterly basis, called the coupon rate . This value never changes until the bond is redeemed (called maturity).
However, bonds are traded daily, just like stocks, so they also have a market value – how much money would you make if you sold the entire bond today.
Let’s say IBM issues a 5% bond maturing in 2035. It cost you $ 1,000 to buy it, so you get $ 50 a year for the bond ($ 12.50 a quarter). However, if interest rates rise to 10%, no one wants to buy your $ 1,000 IBM bond. It only brings in 5%, while other new bonds bring in 10%.
So, in order to sell this bond, you have to sell it at a lower price – just enough for its $ 50 coupon rate (which, remember, never changes) is 10%. So people will pay $ 500 for a bond that originally cost you $ 1,000 to get 10% return.
Thus, as long as the interest rate remains the same, the market value of the bond changes with the interest rates: when interest rates rise, the market value of the bond falls. When interest rates fall, the value of bonds rises.
Given that the bond market is more than twice the size of the stock market, you now understand why professional investors follow the Fed like a hawk.
The Fed did not raise interest rates at the March FOMC meeting , but made it clear that it does not exclude an increase in interest rates at the end of this year. When this happens, you can expect the value of your bond funds to drop.
However, as rates rise, so does the return on any new investment in bonds or bond funds. So, if you bought a new bond after interest rates went up, it will be worth more than the bond you bought back when interest rates were low.
Therefore, when looking at your bond investments, it is important to distinguish between your previous investment and what you will invest in the future.
Option one: stay on course
Some experts say that you should simply keep your funds and generate income from them. Of course, this means that the value of your existing bond funds is likely to decline as interest rates rise. But even if the price of bond funds may change, these monthly interest payments will remain the same.
And if you invest in bond funds on a monthly basis – this is called dollar averaging – your return on each purchase will increase as interest rates rise.
However, if you are within ten years of retirement and intend to switch your bond funds to other investment vehicles during that time period, this option is probably not the best option because you will lose money by selling those funds. …
Option 2. Try bond funds with different conditions
Others say that you may need to rethink the lifespan of the fund. A bond is a debt instrument, which means that it must be redeemed on a specific date (called the maturity date). Some bonds last 5 years, others 50 years. For example, a 20-year bond issued in 2000 has only five years left to maturity in 2015. Just as not all bonds are the same, not all bond funds are the same. Some funds specialize in shorter-term bonds (both short-term and near-maturity), while others specialize in bonds with longer maturities.
Longer-term bonds usually have a higher yield than shorter-maturity bonds, but they also carry a higher risk of loss. This is a classic trade-off between risk and reward.
Therefore, it should come as no surprise that rising interest rates have a greater impact on the value of bonds and funds with longer maturities. Vanguard offers a great slider to visualize this.
The more you move to short-term bond funds, the less you will be affected by the rise in interest rates (but the lower your overall return will be).
Option three: prepare your portfolio rebalancing
If you are like many people who invest on a monthly basis, you may want to consider another tactic: rebalancing your portfolio to take advantage of lower bond prices. As interest rates rise, you will notice that the value of your bond funds will decline. If the rise in interest rates is minimal, your impact will be too, but if interest rates rise significantly, your portfolio could be hit hard. Rebalancing before the interest rate goes up can help you get around this.
Suppose that in the long run you want to hold about 20% of your total investment portfolio in bond funds. Obviously, you want to minimize the damage that 20% will incur when interest rates rise. So here’s what you do:
- Ease your existing bond funds before interest rates rise to below your ideal. Let’s say 10%. This will allow you to sell these bond funds at a higher price before they start to fall.
- You still want about 20% of your portfolio in bonds, so increase your monthly purchases after interest rates rise. The prices of these bond funds will fall, so instead of allocating the usual 20% of your monthly purchases to bonds, allocate 30% or more of your monthly purchases to bonds.
After a while, 20% of bond funds will reappear in your portfolio. But you would pay less because you sold when the cost was higher and re-bought when the cost was lower. Overall, in dollars, this is unlikely to be a game changer, but if you’re willing to put in a little effort, you’ll be rewarded with slightly higher returns.
