Conservative investors are becoming increasingly concerned that their bond holdings may be at risk. If and when the Federal Reserve Bank hikes interest rates this year, will bond holders be caught holding the bag?
It depends. The short answer would be that when interest rates rise, bond prices fall, if all else remains equal. That’s because bonds have two sources of returns: changes in price and interest payments that move in opposite directions. If you hold your bond investment until the date it matures (whether that is a few months or as long as thirty years), you receive all the interest payments the bond pays out plus your original investment money back at maturity providing you purchased it at par (the price it was initially offered).
For those of you who plan to hold your bonds to maturity and are happy with your present rate of interest, then there is nothing to worry about. Rates can rise all they want but why should you care?
The problem for many elderly, fixed income investors is that they are not sure they can wait the five, ten, twenty (and certainly not thirty years) necessary to cash in their bonds at par. Secondly, most retired investors acknowledge that at the present rate of interest income received, they can’t make ends meet. So rising interest rates for them is a double-edged sword. It means that in the future the stream in interest income from bonds will improve, but bonds they hold now will go down in price at the same time.
If we focus on individual bonds in the short-term, when interest rates move up, basic bond math indicates that prices generally will decline. Price history also indicates that the longer the maturity of your bond, the steeper the decline. Therefore long-dated, low interest individual bonds are the most risky investments you can hold in a rising rate environment.
On the other hand, bond funds usually decline less (but they still decline). Bond funds have a wide array of short, medium and long-term bond holdings that mature during different times with different rates of interest. That lessens the impact of interest rate increases over time.
Remember, too, that despite rising rates (or even because of them), governments and corporations must continue to raise money in the debt markets. Plants still need to be built, roads paved, and government programs financed but now the cost of borrowing is higher. There is usually a ready market for these higher yielding bonds depending on the quality of the issuer.
As interest rates rise, bond buyers, including bond fund managers, are always buying and selling lower yielding bonds for higher yielding bonds. That tends to lessen the price depreciation they suffer over time. As long as interest rates do not rise too fast, most managers can stay ahead of the curve. They can offset price declines in their portfolio of bonds by buying bonds with higher interest payments over a longer period of time.
In summary, individual bonds are riskier than bond funds generally speaking. In our next column we will discuss the risks of different types of bonds and strategies to reduce that risk going forward.