Bonds: Preparing for Rising Interest Rates

Historically, people have looked to bonds for stability, income, and security. As people approach retirement, they tend to take a more conservative risk position with their portfolio. The more conservative people become with their investments, the more bonds they typically add to their mix. For some time now interest rates have been falling or have stayed relatively stable. If that trend changes and interest rates move up, then the value of your bonds may go down.

What are bonds? Bonds are debt issued by corporations and governments. Typically these loans run from 30 days to 30 years. Generally speaking, the longer the term of the loan the greater amount of interest paid to the holder of the bond.

An investor may pay $1,000 per bond and receive an agreed-upon rate of interest for the term of the bond. So long as the company (or government) remains solvent, the investor should receive the dividends from the bonds, and, when the term is complete, the investor should receive a return of their $1,000 principal payment.

How do interest rates impact bonds? Bonds typically change value from their original $1,000 as interest rates change. You’ll find that bond values generally move inversely to interest-rate changes. This means that a decrease in interest rates could increase the value of bonds and that an increase in interest rates could drive down the value of bonds.

As an example, let’s say that you want to buy a bond. The current interest rate is 2%. If you want, you could buy a new issue bond for $1,000 at 2% interest. You could also purchase a bond from someone looking to sell his/her bond. If someone purchased a bond with a 1% interest rate, they’d have to decrease the bond’s value from $1,000 to provide you with a competitive interest rate. This is done because an investor is unlikely to want to buy a bond for 1% from someone when they could buy a new-issue bond for 2%.

The amount at which the selling party would have to decrease the value of the bond depends in part on the term of the bond. The longer the term, the more he/she’d have to decrease the value. The shorter the term, the less he/she would have to decrease the bond’s value.

What can you do to help minimize the impact of rising rates on your bonds? Depending on your current income needs, comfort level with a fluctuating portfolio value, and liquidity needs, you could see several options. You could stay the course, move to shorter-term bonds, and/or move toward cash.

Some investors, who hold individual bonds, will want to keep their bonds intact. Knowing that a solvent company is expected to provide a return of principal upon maturity, they may not be concerned about the bond’s change in value.

Other investors who are concerned about loss of value may look to invest in shorter-term bonds. This is because shorter-term bonds are typically less volatile if all other factors are the same. The other positive to owning shorter-term bonds is that they mature sooner. With a shorter maturity, the investor may be able to buy new bonds with higher interest rates thus increasing his/her income.

Floating-rate securities are another option. Floating-rate debt is often higher-risk loans or bonds that come with variable interest rates. The rates can go up or down every 30 to 90 days based on changes in a predetermined benchmark (such as Libor) and often have a minimum interest rate. Because the interest rate paid often goes up as rates go up, there’s typically less volatility in price with floating-rate securities than with traditional, fixed-rate bonds during periods of interest-rate increase. Due to floating-rate debt often being issued by higher-risk companies, they still contain the possibility of loss of principal and can vary in price based on the health of the companies who issued the debt.

Other options include moving to investments such as CDs or money markets. While they may pay less interest, they tend to have a greater level of principal security.

Fearful of losing any value in bonds and able to withstand a potential decrease in income, some investors may opt to move some of their bond portfolio to cash.

One or all of these options may be appropriate and should be assessed on an individual basis. Consult your financial advisor for specifics regarding your situation and consult your tax advisor about the tax implications of selling bonds prior to maturity.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. High yield / junk bonds (grade BB or below) are not investment-grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.