Worried about how to preserve principal in a rising rate environment? Unfortunately, there is no risk-free lunch these days. Everything has some element of risk: market risk, inflation risk, interest rate risk, credit risk, etc.
Bonds have traditionally been a more conservative investment and a way to help preserve principal for many investors over the past 30 years. However, in a rising rate environment bonds may be less conservative than you think.
I will spare you the math, but the gist of is this: when interest rates rise, bond prices tend to fall. The reason is that an investor has no incentive to buy your bond that pays 2% interest, when a new bond paying 3% has just been issued. The only reason he would buy your bond is if the yield on yours was equivalent to the 3% he can get elsewhere in the market. Hence, rising rates tend to sink bond prices.
What does this mean for your bonds?
Earlier this year, the Federal Reserve indicated that they may begin to “taper” or dial back their bond buying program known as QE3. Although the Fed hasn’t formally raised interest rates, they have said that they could begin raising rates at some point in the near future – perhaps sooner than expected.
So if not directly, then indirectly, rates may rise as the Fed begins to taper their bond buying program.
Most investors understand that bond prices drop when interest rates rise. I believe bond prices will drop as soon as the market anticipates that rates are going to rise. We may be experiencing that now as the bond market has sold off earlier this year in response to Bernanke’s comments.
When rates go up and to what level is anyone’s guess. In recent years, the Fed Funds Rate which currently sits at 0.25% was as high as 5.25% in 2006. In 1981 the Fed Funds Rate was an eye popping 18%-20%! (http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html).
It’s possible the Fed may wait quite a while before they formally raise rates. Or they may raise rates only modestly and keep them at those levels for years. We don’t know.
If rates rise, what’s an investor to do?
I can’t provide financial advice or product recommendations in a blog post, but here are some common sense ideas that you might consider.
- Talk to your financial advisor. Have them review with you your bond positions and their vulnerability in a rising interest rate environment. Discuss alternatives to bonds.
- Know what you own. Some investment portfolios might have a considerable portion allocated to bonds, and you may not know it. Do your research and find out how much of your investments are in bonds and what type. How sensitive are they to changes in interest rates? What is the investment manager doing to address interest rate risk?
- Consider other options. Not all income oriented investments are bonds, and not all bonds are equally sensitive to interest rate changes. It may make sense to look at other options as you do your investment planning.
If you have questions regarding this post or to review your investment allocation, contact me at firstname.lastname@example.org.
Note: Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Past performance is not a guarantee of future results. Please note that individual situations can vary. In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. Bonds are also subject to other types of risks such as call, credit, liquidity, interest rate, and general market risks.
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