Following 11 consecutive interest rate hikes, the Federal Reserve Bank held interest rates steady at a range of 5.25 percent to 5.50 percent in September 2023. For some investors, rising interest rates may present market opportunities and a potential increase in income; for others, a watchful eye may be needed. A key investing strategy to consider in the current environment is managing sensitivity to this interest rate risk and inflation expectations.
One of the basic concepts of bond investing is the inverse relationship between interest rates and bond prices. As interest rates rise, bond prices fall, causing a loss in current value. Further, the longer the period until a bond’s maturity, the more sensitive the bond price usually is to changes in interest rates. This can be especially true for bonds with zero or low coupon payments.
For example, consider an investor who today puts $5,000 in 10-year Treasury bonds paying a coupon rate of 4.75 percent. Fast forward two years, when interest rates rise to 6 percent. If the investor needs to sell those bonds, he/she may have difficulty unloading them in a market where newer bonds offer higher interest. The investor will likely receive less for the bonds than he/she originally paid. This makes sense, as it could be rare for someone to want to buy a bond that pays a 4.75 percent interest when many other bonds pay 6 percent. The longer the time the bond matures, the more uncertainty and risk the investor may face.
However, not all bonds are created equal. Some will be more sensitive to rising interest rates than others, and even those more sensitive may play an essential role in smoothing investment portfolio volatility. Low-coupon bonds, zero-coupon bonds and very long-term bonds tend to be most sensitive to changes in interest rates and usually have more risk as rates rise. High-coupon bonds, short-term maturity bonds and even low-credit-quality bonds tend to be less sensitive to interest moves (although low-credit-quality bonds are subject to other risk factors).
Another critical point to remember is that the Fed’s interest rate hikes increase the very short-term rate with no influence over other longer-term rates. Therefore, short-term rates may rise while longer-term rates stay level. This is called a “flattening” of yields, for which the difference between short-term and longer-term rates shrinks. In this example, short-term bonds may do much worse than longer-term bonds. What is an investor to do?
The tried-and-true concept of portfolio diversification can be as crucial with stocks as with bonds. It is difficult for investors to pinpoint exactly what the bond market and the Fed will do in the future. One approach investors may consider is to focus on their personal saving and spending goals while building and maintaining an investment strategy consistent with their unique individual situation.
Savvy investors can understand these issues and help minimize their interest rate risks through asset diversification. For example, investors may buy bonds of different maturity, credit risk and class, including government, corporate or municipal bonds. They also may balance out their investing risk by putting money into mutual funds that include bond investments and/or investing in a mix of less sensitive bonds or bond funds with riskier but potentially higher-yield equity investments.
About the Author: Todd A. Moll, CFP®, CFA, is a director and chief investment officer with Provenance Wealth Advisor (PWA), an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs and a registered representative with PWA Securities, LLC. He can be reached at the firm’s Fort Lauderdale, Fla., office at (954) 712-8888 or firstname.lastname@example.org.
Provenance Wealth Advisors (PWA), 200 E. Las Olas Blvd., 19th Floor, Ft. Lauderdale, FL 33301 (954) 712-8888.
Todd A. Moll, CFP®, CFA, is a registered representative of and offers securities through PWA Securities, LLC, Member FINRA/SIPC.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct.
Any opinions are those of the advisors of PWA and not necessarily those of PWA Securities, LLC. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of PWAS, we are not qualified to render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional. Prior to making any investment decision, please consult with your financial advisor about your individual situation.
Every investor’s situation is unique, and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of the strategy selected. There is an inverse relationship between interest rate movements and fixed-income prices. Generally, when interest rates rise, fixed-income prices fall, and when interest rates fall, fixed-income prices generally rise.
Posted on November 21, 2023