Buying Bonds in a Rising Rate Environment
Written By: Michael Carbone, CFP®
Investors often invest a portion of their money in bonds to try to offset the rising cost of living over time. Bond investments are generally used by investors to:
- Reduce the overall risk/volatility of their investment portfolio
- Generate income for spending in retirement
A bond (fixed income) investment is made when an investor lends their money to another party i.e., bank, corporation, government, municipality, etc. for a pre-determined period.
The borrower (bank, corporation, government, municipality, etc.) pays you (the lender) a return via interest payments.
- Generally, the higher the risk of the borrower defaulting on their obligation (i.e., a public company vs. the federal government), the higher the yield should be.
Unlike stocks, which do not “mature,” you receive your face value back upon maturity of a bond.
- If you sell a bond prior to its maturity, you sell at the prevailing market price. Market prices move inversely with interest rates. This is referred to as “interest rate risk.”
- If market interest rates have moved higher since your original purchase, you’ll generally receive less for your bond.
- If market interest rates have moved lower since your original purchase, you’ll generally receive more for your bond.
- Again, if you hold a bond to maturity, you’ll receive the face value.
- Generally, the further out your bond’s maturity, the higher the yield.
- Generally, the further out your bond’s maturity, the greater the potential volatility with market interest rate movements.
So, what do rising interest rates mean for bond investors?
It means you may lock in a rate today that looks low in the future. Also, as interest rates rise, bond prices tend to fall. So, why invest in bonds when interest rates are rising? Because there are few alternative options available that don’t require incremental risk be taken. Even if bond returns are expected to be below average, it’s important to recognize their primary purpose in your portfolio – to manage risk.
How can individual investors manage their bond portfolio during periods of rising interest rates? Investors may:
- Build a bond ladder to diversify the maturity dates of the bond portfolio. This may be a hedge against both rising and falling rates because:
- As interest rates rise, maturing bonds may be reinvested to higher yields.
- As interest rates fall, we lock-in today’s high yields.
- Keep in mind, although the media is focused on rising interest rates, rates may also move lower and may stay low for many years (we’ve seen this movie).
- Hire a professional bond manager (i.e., mutual fund).
- Many bond professionals have the resources and expertise to potentially benefit from future interest rate changes – both to the downside and upside.
Michael Carbone, CFP®
Past performance is not indicative of future results and there is no assurance that any investment strategy will be successful.
Investing in fixed income securities (aka “bonds”) involves certain risks such as market risk, if sold prior to maturity, and credit risk, especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than original cost upon redemption or maturity. Bond prices fluctuate inversely to changes in interest rates. In other words, if interest rates rise after your purchase, you may receive less than your purchase price should you liquidate early, and vice versa. Bonds provide a fixed rate of return if held to maturity.
Any opinions are those of Michael Carbone - not necessarily those of Raymond James. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that is accurate or complete. Expressions of opinion are as of this date and are subject to change without notice. Investing involves risk and you may incur a profit or loss regardless of strategy selected.
Investors should carefully consider the investment objectives, risks, charges and expenses of mutual funds before investing. The prospectus and summary prospectus contain this and other information about mutual funds. The prospectus and summary prospectus are available from your financial advisor and should be read carefully before investing.