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Bonds, bond funds, and interest rates

December 15, 2014

With the end of the Fed’s bond buying program, we know that the days of perpet­ually low interest rates are ending. When bonds are a part of your in­vestment port­folio, rising interest rates can present a challenge.

First, we know that when interest rates rise, the market price of bonds moves in the opposite direction. Why? Let’s assume you’ve purchased a $10,000 face value bond (you paid par, or $10,000 for it), with a maturity of ten years, and a coupon (i.e., interest rate) of 5%. For the ten years you own the bond, you collect $500 per year (=10,000 x 5%), and if you bought a high quality bond, you eventually get back your face value of $10,000 at maturity. Now, let's assume that interest rates rise to 6% during the time you own your bond. In this scenario, your 5% bond is not worth as much as it was when you bought it. This is because investors can purchase a $10,000 bond that pays 6% ($600/year) so they would not want to pay $10,000 for your 5% bond ($500/year). In this example of rising interest rates, the value of your bond would be less than $10,000 if you want to sell it prior to maturity. Using the same logic, the oppo­site would occur, and your bond would be worth more, if rates were to drop while you owned the bond. So, the market value of a bond will fluctuate as interest rates rise and fall. The same happens to bond funds; but there is a major difference.

If you are a shareholder in a bondfund during a period of rising rates, the bond fund value will drop just like the market value of the bond described above. But the bond fund has no maturity date (i.e., you simply own a share of a fund), so you cannot just hold it until maturity and collect your full face value. If you own an individ­ual bond none of this price fluctua­tion means very much because when your bond matures, you will receive 100% of its face value. With all of this in mind, here are a couple of ideas that may help to mitigate risks in a rising rate environment.

  • Consider investing in individual high quality bonds instead of bond funds in a rising rate environment, as explained above;

  • Invest in shorter term bonds with varying (i.e., laddered) maturities. Bonds with longer maturities will be hit harder when interest rates rise, and laddering keeps your portfolio from becoming due all at the same time. It is important to note, how­ever, that bond managers need a certain minimum amount in order to ladder properly; and

  • Since you generally own bonds for income and safety, don’t simply invest in the highest yielding bond unless it is high quality.

Let’s discuss your individual fixed in­come needs at your earliest convenience.

*Investing in fixed income securities involves credit and interest rate risk. When interest rates rise, bond prices generally fall. This effect is usually more pronounced for longer-term securities. You may have a gain or loss if you sell a bond prior to its maturity date.