Managing Bond Investments As Interest Rates Rise

by Crista Huff

(originally published July 6, 2015)

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Bond investments can be a low-risk way to invest, providing a better income stream than you might otherwise receive from a bank. But there are some pitfalls. 

At first glance, rising interest rates might make you say “Oh boy, I’m finally going to get more income from my bond investments!” But that’s not necessarily the case. Here’s the downside to rising interest rates, and how to solve the problem.

 

Rule #1: Don’t own bond mutual funds when interest rates are rising. (Notice that I didn’t say not to own bonds; I said not to own bond mutual funds.)

Bonds prices and bond interest rates work like a seesaw, within your bond portfolio. (I am specifically talking about bonds which you already own, not bonds which you might purchase.)

When bond interest rates rise, the value of the bonds which you already own goes down.  And here’s why: Let’s say that you buy a $10,000 bond with a 4% interest rate and a five-year maturity. Then interest rates rise, and another investor can buy a newly issued $10,000 bond with a 5% interest rate and a five-year maturity. You cannot sell your $10,000 bond at full price when more attractive bonds are available.

Therefore, when you look at your account statement, the value of your $10,000 bond might be more like $8,000.  Whoa!

Do the math: your bond pays $400 per year. People want bonds yielding 5%. The only way somebody’s going to buy your bond from you is if it yields 5%. And the only way your bond can yield 5% is if the price drops to $8,000.

When a $10,000 bond pays $400 interest per year, the yield is 4%.

When an $8,000 bond pays $400 interest per year, the yield is 5%.

If you’ve never thought about that before, your eyes might be popping right now. “I thought bonds were supposed to be SAFE?!” 

This pricing risk becomes paramount when you need to sell your bonds prior to maturity, to cover unexpected expenses. But fluctuations in bond values can be ignored if you hold your bonds until they mature.

 

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Rule #2: No matter where interest rates go — up or down — your $10,000 bond is going to be worth $10,000 upon maturity. 

As long as the bond is guaranteed, pre-refunded, or issued by a highly-rated corporation, you’re going to get all your money back upon the bond’s maturity, plus all the interest you earned along the way. (As opposed to junk bonds, which have low-quality ratings because they’re issued by financially shaky corporations and municipalities. Junk bonds have a higher risk of default.)

Most people will own their bonds within investment accounts, as opposed to holding bond certificates in a safe. The brokerage firm will automatically refund the bond for you, and put $10,000 cash into your account (plus any final interest payment that’s due). The brokerage firm will not automatically buy you another bond*. Instead, the cash will likely go into a low-interest bearing money market fund, where it will sit until you make a subsequent investment decision.

However, if you invested your “safe” money in a bond mutual fund during a time period when interest rates were rising, your principal will decrease. The share price of your bond mutual fund does not have a maturity. It is not going to rise back up to the price that you paid.

While it is true that your bond mutual fund might eventually pay you more monthly income, during periods of rising interest rates, that’s not going to happen quickly, and it’s not going to offset the decrease in your principal value.

A bond mutual fund is a portfolio of bonds which is managed by an investment professional. The portfolio manager is going to buy new bonds, at higher interest rates, as bonds within the portfolio mature. But if interest rates rise over the next two years, and only 20% of the bonds within the portfolio mature, you’re going to own a mutual fund in which the majority of bond values have decreased, and maybe 20% of the portfolio — which was recently reinvested at higher interest rates — maintained a steady value. 

To recap, 80% of the portfolio’s bonds decreased in value, and 20% of the bonds maintained steady values while providing slightly higher interest income to the portfolio. Overall, that’s a losing proposition.

*Sometimes banks automatically buy you another CD, shortly after maturity, but brokerage firms do not do that.

 

Rule #3: It can be profitable to own bonds, and bond mutual funds, during periods of falling interest rates.

Remember the bond price/interest rate seesaw? It swings both ways. When interest rates are falling, the value of your bonds, and of your bond mutual funds, will increase. Over time, the bond mutual fund will yield less and less, but its principal value will rise. And if you own individual bonds, you’re going to see their values increase on your account statements. 

 

Rule #4: You can safely navigate a multi-year period of rising interest rates by using a laddered bond portfolio strategy.

A laddered bond portfolio is comprised of an assortment of bonds with rising maturities. For example:

• the portfolio is divided evenly among bonds coming due in each of the next five years; 

• or the portfolio is divided evenly among bonds coming due in two, four, six, eight, and ten years.

In the first scenario, each time a bond comes due, the investor purchases a five-year bond, thereby extending the maturity on the bond portfolio, and locking in a higher interest rate than he was receiving on the bond that just came due. 

In the second scenario, the investor uses her principal to buy ten-year bonds; again, extending the portfolio’s maturity and increasing the portfolio’s yield.

This strategy can work with certificates of deposit (CD’s), Treasury bonds, corporate bonds, and municipal bonds. It can work with guaranteed or pre-funded bonds, high-quality bonds, or junk bonds; depending on the amount of risk the investor is willing to accept. 

With a laddered bond portfolio, you benefit by gradually increasing your bond income, while minimizing the pricing risk associated with owning bonds during periods of rising interest rates.

 

The Federal Open Market Committee (FOMC) openly stated their intent to increase interest rates over the course of the next several years. (Please see my recent report on the Federal Reserve’s June meeting.)

Investors can confidently look forward to the prospect of earning higher income from their bond investments. By incorporating a laddered bond portfolio strategy, you can respond to the changing interest rates with flexibility, by taking advantage of higher earning power, while preserving principal.

 

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Happy investing!

 

Crista Huff

President

Goodfellow LLC

 

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