As we move into a period when interest rates could be on the rise, many are left wondering what could happen to the bonds in their portfolio. This month I discuss some potential impacts of rising rates and options for fixed-income investors.
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Bonds: Preparing for Rising Interest Rates
Historically, people have looked to bonds for stability, income, and security. As people approach retirement, they tend to take a more conservative risk position with their portfolio. The more conservative people become with their investments, the more bonds they typically add to their mix. For some time now interest rates have been falling or have stayed relatively stable. If that trend changes and interest rates move up, then the value of your bonds may go down.
What are bonds? Bonds are debt issued by corporations and governments. Typically these loans run from thirty days to thirty years. Generally speaking, the longer the term of the loan the greater amount of interest paid to the holder of the bond.
An investor may pay $1,000 per bond and receive an agreed upon rate of interest for the term of the bond. So long as the company (or government) remains solvent, the investor should receive the dividends from the bonds, and, when the term is complete, the investor should receive a return of their $1,000 principal payment.
How do interest rates impact bonds? Bonds typically change value from their original $1,000 as interest rates change. You’ll find that bond values generally move inversely to interest rate changes. This means that a decrease in interest rates could increase the value of bonds and that an increase in interest rates could drive down the value of bonds.
As an example, let’s say that you want to buy a bond. The current interest rate is 2%. If you want, you could buy a new issue bond for $1,000 at 2% interest. You could also purchase a bond from someone looking to sell his/her bond. If someone purchased a bond with a 1% interest rate, they’d have to decrease the bond’s value from $1,000 to provide you with a competitive interest rate. This is done because an investor is unlikely to want to buy a bond for 1% from someone when they could buy a new issue bond for 2%.
The amount at which the selling party would have to decrease the value of the bond depends in part on the term of the bond. The longer the term, the more he/she’d have to decrease the value. The shorter the term, the less he/she would have to decrease the bond’s value.
What can you do to help minimize the impact of rising rates on your bonds? Depending on your current income needs, comfort level with a fluctuating portfolio value, and liquidity needs, you could see several options. You could stay the course, move to shorter-term bonds, and/or move toward cash.
Some investors, who hold individual bonds, will want to keep their bonds intact. Knowing that a solvent company is expected to provide a return of principal upon maturity, they may not be concerned about the bond’s change in value.
Other investors who are concerned about loss of value may look to invest in shorter-term bonds. This is because shorter-term bonds are typically less volatile if all other factors are the same. The other positive to owning shorter-term bonds is that they mature sooner. With a shorter maturity, the investor may be able to buy new bonds with higher interest rates thus increasing his/her income.
Floating-rate securities are another option. Floating-rate debt are often higher risk loans or bonds that come with variable interest rates. The rates can go up or down every 30 to 90 days based on changes in a predetermined benchmark (such as Libor) and often have a minimum interest rate. Because the interest rate paid often goes up as rates go up, there’s typically less volatility in price with floating-rate securities than with traditional, fixed-rate bonds during periods of interest-rate increase. Due to floating-rate debt often being issued from higher-risk companies, they still contain the possibility of loss of principal and can vary in price based on the health of the companies who issued the debt.
Other options include moving to investments such as CDs or Money Markets. While they may pay less interest, they tend to have a greater level of principal security.
Fearful of losing any value in bonds and able to withstand a potential decrease in income, some investors may opt to move some of their bond portfolio to cash.
One or all of these options may be appropriate and should be assessed on an individual basis. Consult your financial advisor for specifics regarding your situation and consult your tax advisor about the tax implications of selling bonds prior to maturity.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
The opinions voiced in this material are for informational purposes only and are not intended to provide specific advice to any individual. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
Debbie has been serving as PWM’s intern for the past year. Starting on July 10th, Debbie will be working full time as a paraplanner. Debbie will be taking over the office’s administrative duties, helping with various behind-the-scenes tasks for clients, and working on getting her licenses so that she too can work directly with clients. It’s an exciting change and I’m looking forward to helping Debbie succeed in her role.
Heidi will continue doing administrative work through the summer. The idea has always been that Heidi was helping fill a temporary need at PWM and will be moving on to fulfill her career and personal goals. I greatly appreciate all that Heidi has done these past six months. As sad as I will be to see Heidi leave, I think that Fenway and Roxy will be devastated.
July 3rd through July 7th:
Our office will be closed the first week of July. I will periodically check email and voicemail. If you have an urgent, account-related need, please call TD Ameritrade at 1-800-431-3500. Please note the US markets and TD will be closed on Tuesday, July 4th. The US markets will also be closing early on Monday, July 3rd. I hope everyone has a great Independence Day!
While I will be out of the office these days, I will periodically check email . Debbie should be available at the office should you need anything. If you have an urgent, account-related need and cannot reach Debbie, please call TD Ameritrade at 1-800-431-3500.
Just a Reminder
We are always accepting donations for the local animal shelters – toys, tennis balls, collars, leashes, food, cat litter, cardboard trays, office supplies, cleaning supplies, towels, mats, washcloths, etc. We will accept donations Monday-Friday between 9am & 5pm.
Elise had a wonderful 3rd birthday. It started with a party and fundraiser the week before and continued with a family staycation the week of her birthday. During our staycation, we took some time to be tourists. We rode the water taxi to Fells Point one afternoon and took a day trip to Annapolis on another. We also had a couple days at the pool, set up an outdoor art studio for Elise, took Elise to the Disney store for the first time (which was an experience), and enjoyed some family pool time at the house. It was a restful and enjoyable time for the whole family.
I hope you enjoyed this month’s newsletter.
Woody Derricks, CFP®, ADPA®
CA Insurance License #0C40217
Available by Appointment in Alexandria & DC
As a Registered Investment Advisor (RIA), Partnership Wealth Management is committed to providing our clients with financial planning and wealth management services to help them make the most of their investments. At Partnership Wealth Management, we have a long history of working with the LGBT community. Among the many services we offer are financial planning and estate planning strategies for gay and lesbian couples. Financial planning is an important part of preparing for the future; contact us today to get started.
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