Market Beat: Fixed income strategies for rising interest rates
Most investors, especially older ones, have some allocation to bonds in their portfolios. Bonds are part of an asset allocation strategy to provide income and lower risk. All stock portfolios will be typically be more volatile than stock and bond portfolios.
Even though bonds are less risky than stocks overall, they still have risk and that risk comes in a couple of different forms.
One type of risk that bond investors face is known as default risk or credit risk. That’s the risk of an issuer defaulting and not making the coupon payment or repaying the principal at maturity. Low credit quality bonds, also known as junk bonds can have a high default rate in times of economic recession. Historically, the default rate has been about 40 percent during some major recessions.
Credit risk can be managed to some extent through diversification. Junk bonds might be an area where using a mutual fund can have advantages over purchasing individual bonds.
Interest rate risk is different and something that bond investors are seeing today. In a rising interest rate environment, the value of bonds will fall. The amount that a bond will drop in value with a 1 percent interest rate increase can be calculated by using a mathematical formula known as the duration. You can calculate the duration of an individual bond or an entire portfolio of bonds. If you have a bond mutual fund the duration should be provided in your reports.
Bonds with longer maturities are going to be more sensitive to changes in interest rates than bonds with shorter maturities. If you hold bonds with long maturities and interest rates rise, the market price of those bonds will drop and if you decide to sell them prior to maturity, you’ll have to do so at a loss. If you decide to hold them until maturity and the issuer doesn’t default, you’ll get your principal back, but you’ll have to wait until the maturity date.
Laddering is a common fixed income strategy for a rising interest rate environment. You can build a bond ladder by staggering the bond maturities out over several years, that way you’ll have bonds coming due every year and can reinvest the proceeds in new bonds at the higher rates. Rates may not rise that much over the next few years depending on inflation and the economy, but it’s a good idea 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.