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Financial Tip

Financial Tip
Rich Best has spent 28 years in the financial services industry, as an advisor, a managing partner, directors of training and marketing, and now as a consultant to the industry. Rich has written extensively on a broad range of personal finance topics and is published on several top financial sites. Recent books include The American Family Survival Bible and Annuity Facts Revealed: What You MUST Know Before You Invest.

As Interest Rates Rise, a Couple of Key Questions about Bonds

As Interest Rates Rise, a Couple of Key Questions about Bonds

“I thought bonds were supposed to be safe. Why are they losing value?”

Many investors think of bonds as a “promise” from either the federal government or a corporation to pay a guaranteed rate of interest with a guarantee of their principal. And that is true as long as you hold the bond until its maturity, at which time it will repay your full principal. But, should you sell your bond before maturity, it’s no longer a promise; rather it becomes a market-based security subject to price fluctuations.

 Bond prices are sensitive to changes in interest rates. For example, if you purchased a $1000 bond issued by GE with a coupon rate of 4 percent it will be worth less if interest rates rise. Why? Because when interest rates rise, GE would have to issue new bonds with a higher rate of interest if it wants to attract investors. So, the 4 percent bond you own will have less value to an investor who could buy a 5 percent coupon bond for $1000. If you wanted to sell your bond in order to buy a new GE bond with a 5 percent coupon rate, you would have to accept a lower price. But once you sell it, you lose the promise. As with any asset, you can only lose money when you sell it. As long as you hold your bonds to maturity you won’t lose money.

Bond mutual funds are not a promise at all. They are a collection of bonds that are bought and sold by the mutual fund manager, so not only is the mutual fund share price going to reflect the movement of interest rates (price goes down if interest rates go up) it will also reflect the gains and losses of the bonds sold in the portfolio.

“All signs point to rising interest rates in the future which can cause bond prices to decline. Should I be selling my bonds right now?”

While it’s true that bond prices may see a decline should interest rates increase, they are still considered to be a safer investment than stocks when the stock market declines. In their worst year of the last 25 years, the bond market declined just 3.9%. When compared to the worst year for stocks, which was a decline of 38% in 2008, it becomes clear that bonds carry much less volatility than stocks. In fact, in that same year, the bond index gained 5%*. So, from a total portfolio standpoint, bonds can act as a countermeasure to stocks reducing portfolio volatility in any given year.

In an increasing interest rate environment, bonds with shorter maturities (less than five years), react far less to interest rate movement than bonds with longer maturities. They also have lower yields, so you trade higher yields for lower price volatility. Many advisors recommend creating a ladder of bonds based on short, intermediate and long-term bonds to provide greater diversification in the interest-sensitive portion of your portfolio.

A well-diversified portfolio of bonds, as part of an overall asset allocation strategy, can add stability to your long term investment performance. It’s recommended that, depending on your tolerance for volatility in your portfolio, you allocate a portion of your portfolio to bonds.

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