With rates likely to rise in the near future, it makes sense now more than ever for investors to review their portfolios or revisit their interest rate-sensitive investments. Bonds can be an essential part of a conservative portfolio: they provide income and high grade ones are usually considered more stable than stocks.
In most cases, if you are retired and relying on investment income to pay the bills, it’s not appropriate to invest only in equities. Unfortunately, the Federal Reserve’s recent strategy of keeping short-term rates near zero has made it nearly impossible to earn very much on your fixed income investments and cash.
How Do Changes in Interest Rates Affect Bond Prices?
Typically, bond prices and interest rates move in opposite directions. This means that when interest rates rise, bond prices tend to fall; conversely, when interest rates decline, bond prices tend to rise.
When interest rates decrease, the reverse happens. If interest rates had fallen and new Treasury bonds with similar maturities were yielding 2%, you could most likely sell your 3% bond for more than your purchase price.
When evaluating your bond related investments, an important piece of information to look out for is a statistic known as “duration.” In finance, the duration of a financial asset that consists of fixed cash flows, like a bond, is the weighted average of the times until those fixed cash flows are received.
Duration also measures the price sensitivity to yield, the percentage change in price for a parallel shift in yields. Simply said, the longer the duration, the more sensitive a bond is to changes in rates.
Interest rate risk can be simplified by the following statement: when interest rates rise, bond prices fall; conversely, when rates decline, bond prices rise. Therefore, the longer the time to a bond's maturity, the greater its interest rate risk.
Many investors often put a high percentage of their portfolios in bonds for income or to hopefully generate more stable types of returns. This holds especially true when they are very worried about the economy or other financial issues, or after they have taken a beating in stocks. Unfortunately, in a rising interest rate environment, that logic could present problems.
How Much Value Could Bonds Potentially Lose?
The “Change in Interest Rates” table shares the expected loss in market value investors can expect based on rising interest rates. The horizontal axis measures the amount of interest rate increase from 1% to 5%.
The vertical axis is the duration of the bond or bond fund. You should read this like a mileage chart. A bond with a duration of 7 years could lose 21% of its market value if interest rates rose by 3.0%. The longer the bonds duration and the greater the increase in interest rates, the greater the loss.
4 Considerations During a Period of Rising Interest Rates
New risks and opportunities may surface for you as the market responds to changing economic cycles. Keep these considerations in mind before making changes to your portfolio.
1.Maintain complete liquidity for all short-term and near-term needs
Liquid accounts in today’s interest rate environment will probably not keep pace with inflation. Although it is always important to maintain a liquid component in your portfolio, you should think about what major expenses you will incur in the next two years and consider keeping a larger than typical liquid pool of assets.
2.Choose shorter terms over high yields.
Although shorter term bonds yield less than longer term bonds, they typically lose less value when rates rise.
3.Review all of your income oriented investments.
As advisors, we help our clients review the income oriented investments they own. Our primary goal is to match your portfolio to your timelines and personal financial situation.
4.Monitor your portfolio regularly.
Interest rates can move quickly or slowly. In either case we can help monitor your portfolio and suggest adjustments as needed.
Realize Your Financial Goals with Chatterton & Associates
At Chatterton & Associates, we empower individuals and families to achieve their retirement objectives while staying within their risk tolerance. Our team of Certified Financial Planners also adhere to the ethical and legal duties of fiduciaries, always putting our clients’ interests first.
Are you ready to take the next step forward? Request a complimentary in-office consultation today.
This article is for informational purposes only. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice as individual situations will vary. For specific advice about your situation, please consult with a lawyer or financial professional.