Does the impending interest rate hike by the U.S. Federal Reserve have you worried? Interest rate moves influence the return on bonds. Rising rates can translate into bond losses. Is your portfolio prepared for future rate hikes?
Bond prices move inversely to bond yield. This means that as interest rates rise bond prices fall. Think of a child's seesaw. On one end is bond yields. On the other end is bond prices. We have been experiencing falling bond yields for years. That has allowed bond funds to return good returns as their prices have climbed.
Now the U. S. Federal Reserve has indicated it plans to raise rates. The Fed has direct control over the Federal funds rate which is the rate banks use to lend to each other. Of course, this rate affects all the other rates. Rising short term rates force longer term rates to rise. Otherwise, why invest in something for five years when you could get a similar rate at two years. There are times that the inverse does occur (short term rates higher than long term). That is known as an inverse yield curve and easily leads to recession. The last time it occurred we was 2008-2009.
How rising rates will affect bonds depends on several factors. These include the rate of the increase and the frequency of the increase. Unfortunately, both factors are out of an investor's control. What can you do?
Several options are available. Of course, you could always sell all your bonds, but this is not advisable. Bonds are still a balancing, and essential, part of any portfolio. Bonds may lose money when rates rise, but not to the extent that stocks lose. Part of investing is accepting that losses occur in any portfolio at times.
One option is to hold only short term bond funds. Short term funds hold bonds that mature in less than five years. This means that as rates rise the fund will be buying new higher yielding bonds in place of the maturing ones. These higher yields can offset the bond price losses.
Another option is to ladder bonds. Laddering is recommended for individual bonds, but the same can be applied to bond funds. Instead of owning all short term bond funds (and seeing less yield if the Fed doesn't raise rates) or all long term funds (and seeing big losses if the Fed aggressively raises rates), you invest over a range of funds. You spread your money equally over a short term, intermediate term, and long term funds. Add in a little international if you choose. Alternatively, you may want to weight more heavily to the short and intermediate bond funds until rates rise.
Whichever you choose, remember that bonds are needed to stabilize a portfolio. Bond bear markets are never as steep as stock market bear markets. The increased yields on bonds from raising rates will benefit your portfolio in the future.
Investing Books by Sandra Baublitz:
Investing $10K in 2015: Invest Your Windfall for Success (Sandra's Investing Basics Book 3)
The Simple Way to Invest Successfully: A Time-tested Strategy to Growing Your Money