Interest rates have been at historic lows for several years now. So it should come as no surprise to investors that, eventually, rates will begin to rise. While some areas of the economy benefit from rising interest rates, fixed income investments typically don’t fare well.
Interest rates and bond prices generally move in opposite directions. A rise in market interest rates typically means a decline in the prices of fixed rate bonds. If, like many investors, you have chosen bonds to reduce your portfolio’s volatility, rising interest rates may present a reason to revisit your fixed income exposure.
Determine Your Exposure
The first step in determining whether changes to your portfolio are warranted is to review the fixed income investments you currently own. Reviewing the types of bonds you’re holding and their durations can help you assess your portfolio’s vulnerability in a rising interest-rate environment.
Duration is a measure of a bond’s sensitivity to interest-rate movements and can help investors compare bonds with different coupon rates and maturities. The higher a bond’s duration, the greater the bond’s sensitivity to rate changes. Several variables, including time to maturity, enter into the calculation of duration.
Longer Term, Greater Losses
When interest rates are rising, the prices of long-term bonds are generally affected most. Their extended maturity dates generally make them less desirable to investors. Investors who want to sell older bonds generally will have to sell them at a discount to their face value.
Replacing bonds that have maturity dates that are far in the future with shorter maturity bonds may offer some protection when rates are rising. However, keep in mind that these bonds generally pay less interest than longer term bonds.
You may want to consider adding stocks, cash, or other asset classes to a portfolio that is heavily weighted in bonds when interest rates are on the rise. Reducing fixed income holdings might help you avoid substantial losses if interest rates rise dramatically.
Or Different Bonds
This also may be a good time to review the types of fixed investments you hold in your portfolio. For example, convertible bonds are a fixed income investment you might want to consider. Although they tend to pay lower interest rates than standard bonds, convertibles give investors the option of converting bonds into common stock if the company does well. Non-investment-grade corporate bonds (also known as “junk” bonds) typically pay higher interest rates but also present a higher risk of default. Investors need to be cautious.
Help from Laddering
Constructing a bond ladder may offer some protection against rising rates. Laddering involves buying bonds with maturities that are spread out over several years. If rates rise, investors can reinvest the proceeds from maturing bonds at the higher rates.
Fixed income investments provide a hedge against stock market volatility and are an important component of a well-diversified portfolio. Interest-rate risk should be evaluated within the context of your portfolio’s overall risk.
In a changing market environment, the insights and assistance of an experienced investment manager can be invaluable. Click below to contact an investment manager at Security National Bank to discuss your portfolio and its exposure to interest-rate risk.
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