Financial Focus
Own bonds? Be prepared for rate hikes
mind:
If you own bonds, keep this in Bond prices typically drop
when interest rates rise. If rates were to escalate, then, and you own a siz- able amount of bonds, particularly long-term bonds, the value of your portfolio could show a noticeable de- cline. Should you be worried? Actually, no matter where interest
rates go, you can gain some key ben- efits from owning bonds. Specifically, you’ll always receive the same amount of income, based on your bond’s in- terest rate, and you’ll get your prin- cipal back at maturity, provided the bond issuer doesn’t default. Still, you should expect that the market value of your bonds will move higher and lower while you own them. As a re- sult, you should prepare your bond portfolio for a rise in interest rates. Of course, in the past few years,
interest rates have been at or near historic lows. In fact, the Federal Reserve recently voted to keep the federal funds rate — a key short-term interest rate — at the same zero- to-0.25 percent range that’s prevailed since December 2008. With short- term rates so low, many people have
poured almost all their fixed-income investment dollars into longer-term bonds, which generally pay higher rates than shorter-term bonds. Tis could be a problem for these investors because they will be “locked in” to these longer-term vehicles and won’t be able to take advantage of higher interest rates when they arrive. No one can really predict when
interest rates will rise. However, they can’t get much lower than they are now. Furthermore, the economy continues to show signs of recovery — gross domestic product (GDP) grew at a strong 5.7 percent in the final quarter of 2009, according to initial estimates from the Commerce Department — and the Federal Re- serve has historically increased inter- est rates to fight off the inflation that often results from an “overheated” economy. Nonetheless, with no real threat of
inflation on the near-term horizon, and with unemployment still high, the Fed may not be raising short-term rates any time soon. Still, if inflation were to even appear to pick up, inter- est rates could rise without any action
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from the Fed. In any case, the best time for you to act is before interest rates rise; after rates jump, long-term bond prices usually drop more than those of short-term bonds. Tat’s particularly true if inflation expecta- tions rise because long-term rates are affected more by expectations about inflation than by changes in short- term rates by the Fed. So, what can you do to prepare
your bond portfolio in case interest rates rise? One strategy is to create a “ladder” of bonds of varying ma- turities. A bond ladder can provide advantages in all interest-rate envi- ronments. When market rates are low, you’ll benefit from the typically higher rates provided by your long- term bonds. And when market rates rise, you’ll be able to use the pro- ceeds from your maturing short-term bonds to purchase the new, higher- rate bonds. Once you have the appropriate
amount of short-, intermediate- and long-term bonds, strongly consider holding them until maturity. As mentioned above, you’ll receive the same interest payments throughout the lives of your bonds, as long as the issuers don’t default. Plus, you won’t have to constantly worry about where interest rates will be heading next — and in the investment world, the fewer worries, the better.
Tis article was written by Ed-
ward Jones for use by Bill Bough- ton, Weaverville’s local Edward Jones Financial Advisor.
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