For many years, interest rates have been very low. Interest rates will eventually begin to rise. We cannot know when interest rates will begin to rise, how high they will go or how fast the increase will be. Now is the time to make sure your portfolio is properly structured for the inevitable rise in interest rates.
You must understand a basic concept: when interest rates rise, the value of bonds fall. If you own individual bonds, this decline should be temporary until the bond reaches maturity. For bond mutual funds, the decline will be permanent and potentially significant. For this reason, whenever it is practical, we recommend holding individual bonds and not owning bond mutual funds for your fixed income portfolio. (In this article, I’m using the term “bonds” to cover all types of fixed income securities, such as government, corporate and municipal bonds, marketable certificate of deposits, etc.)
When interest rates rise and you own an individual bond, the value of that bond will decrease, but the decline will only be temporary. As the bond nears its maturity date, the price of the bond will increase back to its face value. For example, if you own a $100,000 bond with 5 years remaining to maturity and interest rates rise, the price of the bond will decline, say to $95,000. At the time the bond reaches maturity, you would receive your full $100,000. The key is that a rise in interest rates causes only a temporary price fluctuation for an individual bond.
How much could bond funds decrease in value?
The longer the maturity of the bonds held by a bond mutual fund, the greater the permanent decline in value will be. What was intended to be a safe investment would incur tremendous losses.
- If the duration of the bond fund is 7 years and the rise in interest rates is 3%, the decline in the fund value would be 21%.
- If the duration is 10 years and interest rates increase 2%, the decrease in fund value would be 20%.
- An additional rise in interest rates of another 1%, for a total increase of 3%, would cause that fund to lose a total of 30%.
What do we recommend now?
You should review your fixed income portfolio. If you have a significant portfolio, you should own well diversified, very high quality bonds of short to intermediate length. We do not recommend owning bonds of longer than 7-10 years, depending on the individual and someone’s personal situation.
You should not own bond mutual funds, other than in a 401(k) or similar retirement plan (see below).
If you do own a portfolio of individual bonds, you should be prepared for a temporary decline in the their value when interest rates rise. If you understand this concept, you will understand why this fluctuation is occurring. You will realize why your portfolio value has declined and that you will recoup this “loss” as the bonds reach their maturity dates.
If you do own bond mutual funds, they should be carefully reviewed. We would be pleased to review these funds for you. Now is the time for this analysis. When interest rates rise, and particularly if they rise quickly, it is possible that many investors will pull money out of bond mutual funds and accelerate the price declines. The time to plan for this is now, not when the interest rate increase is occurring.
If you participate in a 401(k) plan or similar type of retirement plan, owning individual bonds is not an option. To own fixed income in these investment vehicles, you need to own a bond mutual fund. We recommend that you hold only shorter term bond funds, with maturity and duration of 4 years or less. With shorter maturities, the fund will be impacted far less by a rise in interest rates. It is also important to review the credit quality of the bond mutual fund, as those holding high yielding (or junk bonds) have been hit the hardest in times of rising interest rates or panic selling in the bond markets.
We hope that you take a close look at your fixed income investments. Review your portfolio and understand if you own individual bonds or bond mutual funds. Contact us if you have questions. We are providing you with clarity and planning that will be important in the future. This type of guidance will provide you with greater security and comfort in the years ahead.