The Federal Reserve has indicated that it might begin raising its target interest rate sometime in 2015.1 Considering that bond prices typically fall when interest rates rise, this may be a good time to examine your fixed-income investments, including individual bonds and bond funds. Here are some factors to consider when reviewing your portfolio.
Maturity and Duration
Holding bonds with shorter maturity dates is one way to address the potential for rising rates. Long-term bonds generally pay a higher coupon rate than short-term bonds; but when rates rise, long-term bond values typically fall. Investors may be reluctant to tie up their money for long periods if they expect a bond’s interest payments to be lower than the rates of newly issued bonds.
A bond mutual fund, which is composed mostly of bonds and other debt instruments, doesn’t have a maturity date. You can gauge the interest-rate sensitivity of either a bond or a bond fund through another measure called duration, which takes into account not only maturity but the value of future interest payments and several other data points. The longer the duration, the more sensitive a security is to interest-rate changes. You can usually find duration with other information about a bond or bond fund.
To estimate the impact of a rate change, multiply a security’s duration by the expected percentage change in interest rates. For example, if interest rates rise by 1%, a bond fund with a three-year duration might be expected to lose roughly 3% in value; one with a seven-year duration might fall by 7%.2 Though this hypothetical example doesn’t represent the return of any specific investment, you can apply the general principle to your own holdings. Keep in mind that even if a bond fund loses value over the short term because of rising interest rates, it still may be an appropriate long-term asset for your portfolio.
The principal value of a bond or a bond fund may fluctuate with market conditions, including changes in interest rates. If you hold an individual bond to maturity, this fluctuation might not matter to you, because you can expect to receive periodic interest payments and the principal when the bond matures, as long as the bond doesn’t default. Of course, shifting value is a key consideration if you want to sell the bond prior to maturity.
A bond fund has different market dynamics than an individual bond, though each fund is subject to the same inflation, interest-rate, and credit risks associated with its underlying holdings. The mix of bonds in different funds may vary widely depending on the fund’s focus and stated objectives. In a rising interest-rate environment, falling bond prices can adversely affect a fund’s performance, and fund managers may be faced with a tradeoff between preserving a fund’s yield at the expense of its market value and preserving the fund’s value at the expense of its yield.
Even if rising interest rates cause some short-term volatility, investors might benefit from higher yields in the long term. By understanding the relationship between rising rates and fixed-income securities, you may be better able to make appropriate decisions regarding your current and future investments.
Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
1) Federal Reserve, 2014
2) Investopedia, 2014
The information in this article is not intended to be tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2015 Emerald Connect, LLC