A key tenet in properly managing investments is a diversified portfolio. One usually contains a mix of stock or stock mutual funds and fixed income investments.
Stock mutual funds are long-term investments that can provide you with growth over time. Fixed-income investments can provide you with short-term liquidity, income, and a buffer against stock market volatility. Bond funds are a staple in most fixed-income portfolios. However, with the threat of rising interest rates, many bond funds may no longer provide the stability you seek in your portfolio.
Interest rates, after dropping close to all-time lows, have begun to increase. The bond market had experienced what is commonly referred to as a 30-year bull market. Until recently, interest rates had been steadily dropping since 1981, resulting in what is referred to as a 30-year bull market for bonds. As interest rates fell, bond owners experienced a corresponding increase in the value of their bonds. Generally, when you buy a bond and interest rates decrease, the market value of the bond rises. On the other hand, if interest rates increase, the market value of the bond drops.
If you hold an individual bond to maturity, assuming the issuer does not default, your entire principal will be returned, regardless of the prevailing interest rate.
Many investors prefer bond mutual funds over individual bonds. Bond funds have experienced dwindling yields lately. As bonds within mutual funds mature, they are replaced with lower-earning bonds.
In this environment, another major concern is potential loss of principal. If many investors decide to sell their bond funds, the fund managers may be forced to sell individual bonds at an inopportune time: before maturity, at less than face value.
The duration of a bond fund is a measure of its sensitivity to changes in interest rates or interest-rate risk. For example, if the duration of a bond fund is five years, and interest rates decrease by 1 percent, the value of the bond fund should rise by about 5 percent. If rates increase by 1 percent, the value of the bond fund should drop by 5 percent. Short-term bonds have a lower duration. The duration of most bond funds are listed at Morningstar.com.
With the threat of higher U.S. interest rates, consider moving your longer term bond funds into short-term bond funds or international bond funds. For greater security of principal, put bonds in a Federal Deposit Insurance Corp.-insured certificate of deposit ladder or equity-indexed CD.
Bond funds usually represent the safe portion of your portfolio, and some of your principal may be at risk as interest rates rise.
Jane Young is a certified financial planner. Email her at firstname.lastname@example.org.