If the Federal Reserve (Fed) raises short-term interest rates this year, as many financial professionals predict, what will it mean to you? As a consumer, you might experience the “ripple” effects if long-term interest rates eventually follow suit, affecting mortgages and other loans. But as an investor, you might quickly feel the impact of a move by the Fed — especially if you own bonds.
In fact, the value of your existing bonds might drop noticeably if interest rates were to rise. That’s because no one will give you full price for your lower-paying bonds when new bonds are being issued at a higher interest rate. So if you want to sell your bonds, you might have to take a loss on them.
Of course, if you were always planning to hold your bonds until maturity, you might not be overly concerned with falling prices. Assuming your bond issuers don’t default — and defaults are rare among “investment grade” bonds — you will continue collecting regular interest payments until your bonds mature, at which point they will be redeemed at full face value. Furthermore, just owning bonds can help you diversify your portfolio, which might otherwise be dominated by stocks and therefore be susceptible to big swings in value. (While diversification can help reduce the effects of volatility, it can’t guarantee a profit or protect against loss.)
However, it’s still useful to be aware of the effects of rising interest rates on bonds of different maturities. Typically, when rates rise, long-term bonds will fall in value more than short-term bonds. So if you only owned long-term bonds, your portfolio could take a bigger hit than if you owned both short- and long-term bonds. Again, this might not be a big issue if you intend to hold bonds until they mature — but if your plans change, a drop in value in your bond holdings could be cause for concern. Furthermore, if you just owned long-term bonds, your money would be tied up, thereby not allowing you to take advantage of newly issued, higher-paying bonds.
You can help protect yourself against the potential negative effects of rising interest rates by incorporating a “fixed-income ladder” in your portfolio. You can build this ladder by purchasing fixed-income securities — such as corporate or municipal bonds — in various maturities. With your ladder in place, a portion of your portfolio matures at regular intervals. Consequently, you can benefit from any increase in interest rates by reinvesting your maturing bonds at the higher rate. And if interest rates should fall, you still have your longer-term bonds working for you. (Generally, longer-term vehicles pay higher rates than shorter-term ones.)
Even if the Fed does raise short-term rates in 2015, it doesn’t necessarily signal the start of a trend. Interest rate movements are notoriously hard to predict — and you probably won’t help yourself by trying to “time” your investment decisions based on where rates may be heading. But techniques such as a fixed-income ladder can work for you in all interest rate environments. So as you think about how you’ll invest in bonds in the years ahead, keep this type of “all-weather” strategy in mind. It may be able to help you keep the “guesswork” to a minimum.
Craig Johnson, AAMS®
513 Oak Avenue
Sulphur Springs, TX 75482