Bonds are appropriate investments when your goal is principal protection. If it is money you need within the next 10 years, you cannot afford to take the risk of equities. Bonds are a solid choice for short-term needs. However, a 2.71 percent interest rate on a 10-year U.S. Treasury bond is not very rewarding. It is even more disillusioning when just three months ago the yield on a 10-year Treasury bond was about 1.91 percent.
So what is ahead for bond prices, and how does it affect you?
First, you must understand the inverted relationship between bond value and interest rates. As interest rates rise, newly issued bonds carry a higher yield. If you want to sell the bond you have been holding, you will likely have to sell it for less than it cost you because the price falls to match higher market yields. This is interest rate risk. When you sell bonds you hold during a period of rising interest rates, you have to be concerned about a real loss.
The Federal Reserve has been keeping interest rates low through their bond-purchase programs for the last five years, while hoping to spark economic activity. However for the last three months, investors have been keeping a close eye on the Federal Reserve’s statements regarding their tapering of bond purchases. With just the speculation of a taper in the Fed’s bond buying, investors sold their bond holdings, driving interest rates up nearly 1 percent. When the Fed does make their move, yields are expected to increase further. This is a negative for current bond investors as well as those who hold bond funds or bond exchange-traded funds.
Current bond investors may be locked into a yield that is below inflation. However, the risk can be greater for bond fund investors. Those who invest in bond funds generally miss out on two key characteristics that owning a bond provide: a fixed yield and a contractual maturity date. The yield on a bond fund “floats” with market yields. As rates fluctuate, yields and prices on bond funds do the same.
When you own a pool of bonds that are constantly maturing, the value of the portfolio is based on the market value of the bonds in the portfolio at any given time. A bond fund portfolio manager rarely holds the underlying bonds to maturity. Therefore, bond funds generally have no guarantee of a specific maturity value on a specific maturity date. If interest rates increase, you could get a negative return on your bond fund investment. Bond prices could fall enough to wipe out any dividend the bond fund may be paying.
If you must invest in bonds during a period of rising interest rates, it may be wise to shorten the maturity to limit downside risk. This should allow you to reinvest in bonds with more favorable yields as interest rates rise.
William G. Lako, Jr., CFP®, is an executive in residence at Kennesaw State University’s Coles College of Business and a principal at Henssler Financial. Mr. Lako is a CERTIFIED FINANCIAL PLANNER™ professional.