Market Beat: Bonds pay out more when interest rates rise
The Federal Reserve Open Market Committee (FOMC) will have its next meeting on interest rate policy on June 13-14. The forecast is for more interest rate increases this year. At the March meeting, the Fed raised the rate to 1 percent from 0.75 percent. The rate could go as high as 2 percent by the end of this year.
Two of the main factors the Fed considers when making interest rate decisions are the strength of the labor market and inflation. Higher interest rates affect borrowers with more cost, and reward investors with higher yields. Mortgages and auto loans become more expensive when interest rates rise.
Bonds will pay out more when interest rates increase. In a normal interest rate environment the benchmark 10-year United States Treasury bond will pay between 4.5 percent and 5 percent; presently that rate is under 2.5 percent. An investor with $1 million saved up could get an income of $45,000 to $50,000 per year by investing in risk free U.S. Treasury bonds normally.
Conservative investors and savers will benefit from higher interest rates. Investors with existing fixed income investments should evaluate their portfolio to determine how sensitive it is to higher interest rates.
Bonds will decline in value as interest rates rise. The amount that a bond will drop with an increase in interest rates can be measured by a complex mathematical formula known as the duration. By calculating the duration of your portfolio, you can estimate the effect rising interest rates will have on your portfolio’s value.
In general, longer-term bonds will be more sensitive to interest rate increases than shorter-term bonds.
Some common strategies for rising rates are known as bullets, barbells, and ladders. If you have a portfolio of individual bonds, you can spread your maturities around in a way that you can adjust to higher rates. If you use mutual funds, you can find the duration of your funds and know what to expect.
Stated maturity funds can be a good tool for diversification, and having control of your maturity dates. Step-up bonds can work well, as they will increase their payments as rates rise. Treasury Inflation Protected Securities (TIPS) work well in an inflationary environment, as their payout is inflation-based.
I don’t think that rates can rise too much in the near term, but it’s always good to be prepared.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.