In March 2018, the Federal Reserve raised interest rates for the sixth time since December 2015 while signaling potentially three additional rate hikes this 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 as the Fed raises rates, it is increasing only the very short-term rate and has no direct control over any 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 actually 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 bond. 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, an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors and Accountants, and a registered representative with Raymond James Financial Services. For more information, call (954) 712-8888 or email firstname.lastname@example.org.
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Todd A. Moll is a registered representative of and offers securities through Raymond James Financial Services, Inc., Members FINRA/SIPC.
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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.