When interest rates rise, the value of your fixed-income investments, such as bonds, will typically fall. If this happens, how should you respond?
First of all, it’s important to understand this inverse correlation between interest rates and bond prices. Essentially, when interest rates rise, investors won’t pay you full price for your bonds because they can purchase newly issued ones that pay higher rates. So, if you sell your bonds before they mature, you could lose some of the principal value.
You may be seeing a price drop among your bonds right now, because interest rates generally rose in 2018 and may continue to do so in 2019. While you might not like this decline, you don’t necessarily have to take any action, particularly if you’re planning to hold these bonds until maturity. Of course, you do have to consider credit risk – the chance that a portion of the principal and interest will not be paid back to investors – but unless the bond issuers default, which is usually unlikely, particularly with investment-grade bonds, you can expect to receive the same regular interest payments you always did, no matter where rates move.
Holding some of your bonds – particularly your longer-term ones – until they mature may prove useful during a period of rising interest rates. Although long-term bond prices – the amount you could get if you were to sell these bonds – tend to fall more significantly than short-term bond prices, the actual income that longer-term bonds provide may still be higher, because longer-term bonds typically pay higher interest rates than shorter-term ones.
To preserve this income and still take advantage of rising interest rates, you may want to construct a “bond ladder” consisting of short-, intermediate- and longer-term bonds. Because a ladder contains bonds with staggered maturity dates, some are maturing and can be reinvested – and in a rising-rate environment such as we’re currently experiencing, you would be replacing maturing bonds with higher-yielding ones. As is the case with all your investments, however, you must evaluate whether a bond ladder and the securities held within it are consistent with your objectives, risk tolerance and financial circumstances.
You can build a bond ladder with individual bonds, but you might find it easier, and perhaps more affordable, to own bond-based mutual funds and exchange-traded funds (ETFs) that invest in bonds. Many bond funds and ETFs own a portfolio of bonds of various maturities, so they’re already diversified.
Building a bond ladder can help you navigate the rising-rate environment. But you also have another incentive to continue investing in bonds, bond funds or ETFs – namely, they can help diversify a stock-heavy portfolio. If you only owned stocks, your investment statements would probably fluctuate greatly – it’s no secret that the stock market can go on some wild rides. But even in the face of escalating interest rates, bond prices generally don’t exhibit the same sharp swings as stocks, so owning an appropriate percentage of bonds based on your personal circumstances can help add some stability to your investment mix.
As an investor, you do need to be aware of rising interest rates, but as we’ve seen, they certainly don’t mean that you should lose your interest in bonds as a valuable part of your investment strategy.
Sean Payne, CFP® can be reached at (562) 596-3722.