Strategies for Managing Rising Interest Rates

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.

Why interest rates matter

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.

Metrics to monitor

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:

  • Duration: A measure of a bond fund's sensitivity to changes in interest rates. Shorter-term bond funds generally have shorter durations and are less sensitive to movements in interest rates than longer-term bonds. If rates rise, the interest rates on bonds with a longer maturity are locked in at a lower rate for a longer period of time. As a result, their prices tend to get hit harder when rates rise. Bond funds also vary based on the average maturity of individual bonds in the portfolio—and are subject to the same principles.
  • Credit risk: The chance one of the investments held by a bond fund will default. A bond issuer’s level of credit risk is one factor that determines the interest rate it must pay on its bonds. Typically, higher-risk bonds pay more interest, and when market interest rates rise, that higher interest can help protect the investor's total return from a price loss driven by rising rates, as long as the economic outlook for the issuers of those bonds remains positive, and issuers are likely to continue paying their obligations.

Strategies to consider

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.

1. Shorten duration

  • What to know: Choosing high-quality bond funds with shorter durations can help to mitigate the effect of rising rates. These bond funds typically pay less than longer-term bond funds, so they may not be right for investors with longer time frames. But the types of bonds held by these bond funds do mature more quickly, allowing the fund manager to put that cash into higher-paying bonds sooner, and that can help to manage one of the challenges of rising rates.
  • UC RSP Funds with shorter durations: UC Savings Fund  

2. Accept more risk for higher interest potential

  • 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.

  • UC RSP Funds that invest in corporate bonds: UC Bond Fund

3. Look for products that adjust to changing rates

  • What to know: If the thought of navigating a changing market seems complicated or daunting, you don’t have to go it alone. A number of investing products aim to help mitigate the impact of rising rates, including funds that invest in Treasury inflation-protected securities (TIPS). In general, TIPS funds are designed to help guard money against the risks of inflation. That’s because these funds invest primarily in inflation-indexed securities issued by the U.S. government. As their name suggests, inflation-indexed bonds pay interest indexed to inflation—that is, their value rises and falls with changes in the inflation rate. As a result, these funds can help provide a hedge against rising inflation.
  • UC RSP Funds that invest in TIPS: UC TIPS Fund and UC Short Term TIPs Fund

The last word

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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