Investors often turn to bonds to add some stability to their portfolios, hoping to balance some of the volatility experienced with stocks. But are bonds really the stable anchors they are made out to be?
Rising interest rates and bonds with declining values illustrate the unique relationship that exists between interest rates and bonds, but more importantly, it shows just how vulnerable bonds are to economic changes that can impact their value.
It is no secret the Federal Reserve will be slowing its bond purchases while raising interest rates, with the end result expected to be lower prices for bonds. Often, investors see this as a sign to dump their bonds. But that isn’t necessarily the only choice.
Fluctuations in interest rates come about due to a variety of economic factors. In fact, both short- and long-term rates are affected by such things as the strength of the dollar, inflation, and the overall pace of economic growth.
Historically, when the Federal Reserve becomes concerned about inflation and fast economic growth, it will attempt to slow the pace by raising interest rates.
Most investors see rising interest rates as the single, largest economic threat to bonds. That’s because in most cases, if you own a bond and interest rates rise, the value of your bond on the open market will fall, with few exceptions.
But an increase in interest rates doesn’t necessarily have to harm your investment. If you are gong to hold your bonds till maturity anyway, the value isn’t going to change just because the interest rate bounces around. You’ll still end up with the the amount promised to you when you purchased your bond, all other factors being equal.
Things get a bit more complex, however, if you own bonds for investment purposes, where you buy and sell them just as you would stocks. In that case, interest rates become critical factors.
Most investors understand that in general, bond prices move in the opposite direction of interest rates. When interest rates begin creeping upward, bond prices start to drop. Likewise, when interest rates are falling, bond prices go up. At least for previously issued bonds trading on the open market.
Typically, what happens is a bond is issued in a certain dollar amount across a set number of years at the current interest rate—$10,000 for five years at 5 percent, for example. But when interest rates rise, the investor finds it impossible to sell the bond. After all, no one is going to want a bond that pays below market rates. This leads to a drop in the bond’s value while interest rates have increased.
Obviously, the investor can’t do anything about the interest rate at the time the bond is purchased. Instead, he or she will have to adjust the purchase price of the bond in order to make the deal work. By paying less for the bond, the new investor is able to weather the lower interest rates.
The reverse is also true. If interest rates rise above the level they were at when you purchased the bond, you can expect to sell it at a price above face value because the fixed interest rate associated with the bond is higher than the market rate.
While an oversimplification, this also illustrates why bonds with longer terms are actually riskier investments than bonds with shorter terms; there is greater opportunity for interest rates to fluctuate.
Virtually any 2014 financial outlook you cared to browse predicted higher interest rates ahead. But so far, increases have been less than newsworthy. Nonetheless, most investors are still anticipating that average rates will rise over the next five to 10 years.
The housing meltdown and economic downturn brought about historically low interest rates as part of the government’s attempts to heal the economy. The economic recovery has been steady, but slow, so that low interest rates remain even as the housing market has begun to gain strength.
While it is expected that bonds will drop as interest rates rise, there is some evidence that investors need not necessarily begin selling their bonds. Historically, bonds have not done as poorly as expected during times of rising interest rates.
Why? The key is likely the increasing yield the overall portfolio was able to earn. This was possible because as bonds matured, investors were able to take the proceeds and re-invest at higher interest rates. This strategy allows investors to more than cover the losses that came about because of higher rates.