One common behavior we see for investors approaching and entering retirement is to become progressively more conservative with their investment allocations. This typically means a growing percentage of fixed income investments in the portfolio with the goal of reducing volatility and producing more income for the saver. While historically, fixed income investments (usually bonds) have been generally less volatile than their equity counterparts (stocks), they are not immune to their own challenges. Rising interest rates are one of those challenges, and rising interest rates have been upon us since mid-2016. So, what does this mean for bond holdings and what can investors do to help prepare to weather this challenging environment?
First off, let's explain the relationship between interest rates and bond values. Interest rates and bonds have an inverse relationship, meaning when rates rise, bond values fall. When rates drop, bond prices rise. If I own a bond that pays 3% interest, but market rates have risen since I purchased my bond and someone can buy a similar bond but get 4% in interest, my bond now has less value. Why would someone want a 3% yielding bond when they can get 4%? An investor would pay less for the lower yielding bond. On the flip side, if I owned a 3% bond and rates dropped and similar bonds were only offering 2%, my 3% bond would have more value. An investor would pay more for the 3% bond. The best way to visualize and internalize this is to picture rates and prices on opposite ends of a see-saw.
Another concept that's important to understand relative to rates and bond prices is something called DURATION. Using duration, you can estimate how much a bond’s price is likely to rise or fall if interest rates change (the bond's price sensitivity), and it can be thought of as a measurement of interest rate risk. The longer the maturity of a bond, the higher the duration. A bond that matures in 30 years is going to have a higher duration and therefore more interest rate sensitivity than a bond that matures in 10 years. If you're thinking about our see-saw, imagine duration as the distance from the center point. The lower the duration, the closer to the center point, and therefore, the less you'd be see-sawing up or down. As you move out towards the end of the see-saw, you're going to be traveling farther up and down. In summary, the longer the duration (or farther from the center point you're sitting), the more your prices will move up or down in response to rate swings.
So, if you're an investor who is looking for lower volatility in your portfolio but is nervous about rising interest rates having a negative impact on the value of your bond holdings, what can you do? At your next portfolio review, ask your advisor what options you have to manage risks from rising rates. And if you really want to impress him/her, ask them about your duration ;).
This is meant for educational purposes only. It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions.
Fixed-income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, corporate events, tax ramifications, and other factors.
The hypothetical examples presented are for illustrative purposes only and should not be deemed a representation of past or future results. The examples do not represent any specific products. Past performance does not guarantee future results.