ReShelle Barrett, CFP®
Most investors believe that owning bonds means an investment with low or no risk. However, bond investments are inherently exposed to certain risks including interest rate risk. And according to most recent comments by the Federal Reserve Board, there is likely at least one interest rate increase on the agenda for this year. Since bond prices act inversely to interest rates, principal will generally decline in a rising interest environment. This is because bonds paying lower rates become less attractive to investors seeking income. Think of it like a seesaw: when rates go up prices go down, and vice versa. The further out you are on the seesaw, the large your “swings” will be. Therefore, shorter maturities can mean less price fluctuation, greater flexibility and greater protection of principal. For example, if you own a bond that pays 2% interest and rates increase to 3%, the bond you own becomes less attractive and thus the price of your bond will decrease if you sell it. On the flip side, if rates fall to 1%, your bond will become more attractive. To further explain, if your bond matures in one year, you are not as likely to be concerned about fluctuating interest rates since your bond will be maturing relatively soon. However, if you own a 30-year bond in a rising interest rate environment, you can expect your price to fluctuate even more since you are committed to a fixed rate for a much longer period of time.
To help decrease some of the risk of owning bonds, we generally suggest investing in a bond mutual fund, and in particular, a fund with shorter maturities. These funds need to re-deploy assets more frequently than longer-term funds, and thus have more opportunity to capture higher yields. Higher interest rates can generate more income for a fund and thereby partially offset price declines sooner.
With current interest rates being as low as they have been in recent years, many investors have taken advantage of high yield bonds/funds. High yield bonds, sometimes called junk bonds, are issued by companies and municipalities judged to have a higher than normal risk of default so to compensate for that risk, these bonds pay higher yields. Since prices of higher yielding, lower-rated bonds are more influenced by this default risk (also called credit risk) than by interest rate risk, these types of bonds tend to do well during economic recoveries because improving business conditions tend to lower the risk of defaults. Also, rising growth strengthens revenues, which help companies pay their debt commitments. Nonetheless, because the default risk is higher, investors need to be conscious of greater risk to principal in high yield bonds.
Time horizon is another crucial factor in selecting a bond investment. If you plan to own a bond investment for the long-term, you will most likely experience several interest rate cycles over that period. By building a “laddered” portfolio where you have bonds with staggering maturities, you can reinvest the principal of a maturing bond in other bonds whose maturity is longer (and yield is higher) than the longest maturity you currently own. For example, you can invest initially in a one-year, two-year and three-year bond. Each year when one comes due, you can simply reinvest those proceeds in a new three-year bond thereby extending your term and your income.
The important thing to remember is that bonds are not a no-risk investment. If used correctly, they can certainly provide attractive income and reduce the volatility of an otherwise all-stock portfolio, but be aware of the risks involved when interest rates begin to rise.