When rates rise, not all fixed income investments have the same reaction.
For the first time in several years the Federal Reserve is raising interest rates. However, some experts believe rates could remain relatively low for some time. Still, if you like investing in bond funds, you need to know how to manage a rising rate environment. Still, if you like investing in bond funds, you need to know how to manage a rising rate environment.
Most bond investments are sensitive to interest rate movements: When rates rise, the prices of bonds generally fall. The good news is that not all bonds are created equal. Some types of bonds typically fare better than others during periods of rising rates—and the same goes for bond funds, which invest in individual bonds.
The key lies in understanding why you own a bond fund in the first place, and how to put together a mix of bond funds that can help you weather a period of rising rates—or potentially even prosper from them.
While rising rates generally aren't good for bond funds, the total return for different types of bond funds can vary widely. There are a number of factors involved, but when trying to assess the impact rates will have on a potential investment, you may want to watch these two metrics:
So, the investing implications seem clear: Rising rates pose a challenge for bond funds in general. But how should you react? Here are strategies to consider.
What to know: If you can tolerate greater credit risk and volatility, consider corporate bond funds. Despite periods of dramatic price changes, over the long term, the relatively high income of the bonds they invest in has contributed the most to the funds’ historic overall return. (Remember, past performance is no guarantee of future results.) Given the inherent credit risk associated with these types of bond funds, you may want to explore a diversified bond fund. These invest in a variety of securities, such as government securities, mortgage-backed securities, corporate bonds, and even foreign bonds.
For many investors, there are good reasons to stick with bond funds no matter what the interest rate outlook may appear to be. No one really knows where interest rates are going or when. And many investors own bond funds because they can help reduce overall volatility in a diversified portfolio. That's because the prices of many types of bond funds have historically moved inversely with stock prices and fluctuated within a narrower range of highs and lows.
As a result, even though bond funds might lag stocks while rates are rising, it may make sense to accept underperformance from that portion of your portfolio for the benefits bond funds can offer when and if the environment changes and stocks struggle. So if you have a long-range outlook and a solid asset allocation, maintaining your current allocation may be a strategy worth considering.
In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk and credit and default risks for issuers, buyers and sellers. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible.
Increases in real interest rates can cause the price of inflation-protected debt securities to decrease.
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