In September 2022, the Federal Reserve Bank raised interest rates for the fifth time this year while indicating plans for additional rate hikes as inflation persists. This latest 0.75 percentage point rate hike brings the federal funds rate to a range of 3 percent to 3.25 percent, up from zero at the start of the year. 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 to investing in the current environment comes down to 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 time period until a bond’s maturity, usually the more sensitive the bond price is to changes in interest rates. This can be especially true for bonds that have 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 2 percent. Fast forward two years, when interest rates have risen to 4 percent. If the investor needs to sell those bonds, he or she may have a hard time unloading them in a market where newer bonds offer higher interest. In fact, the investor will likely receive less for the bonds than he or she originally paid. This makes sense, as it could be rare for someone to want to buy a bond that pays a 2 percent interest payment, when there are many other bonds paying 4 percent. The longer the amount of time until 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 that are more sensitive may play an important 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 important point to remember is that the Fed’s interest rate hikes increase only the very short-term rate and has no influence over the other longer-term rates. Therefore, it is possible that short-term rates may rise while longer-term rates stay level. This is referred to as a “flattening” of yields, for which the difference between short-term rates and longer-term rates shrink. In this example, short-term bonds may do much worse than longer-term bonds. What is an investor to do?
It appears that the tried-and-true concept of portfolio diversification can be as important with stocks as it is with bonds. It is difficult for investors to pinpoint exactly what the bond market and the Fed will do in the future. One approach for investors to consider is to focus on their personal saving and spending goals and building and maintaining their investment strategy consistent with their unique, personal 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/or class, including government, corporate or municipal bonds. They may also 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 along 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 Raymond James Financial Services. He can be reached at the firm’s Ft. Lauderdale, Fla., office at (954) 712-8888 or via email at email@example.com.
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Todd A. Moll is a registered representative of and offers securities through Raymond James Financial Services, Inc., Members FINRA/SIPC.
Raymond James is not affiliated with and does not endorse the opinions or services of Berkowitz Pollack Brant Advisors + CPAs. PWA is not a registered broker/dealer and is independent of Raymond James Financial Services. Investment Advisory Services offered through Raymond James Financial Services Advisors, Inc., and Provenance Wealth Advisors.
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. Any opinions are those of the advisors of PWA and not necessarily those of Raymond James. RJFS does not provide tax advice. You should discuss any tax or legal matters with the appropriate professionals. There is no assurance that the statements or forecasts provided in this material will prove to be correct. Past performance is not a guarantee of future results. Investments mentioned may not be suitable for all investors.
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 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. Prior to making an investment decision, please consult with your financial advisor about your individual situation.
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Posted on December 6, 2022