If you own bonds, keep this in mind: Bond prices typically drop when interest rates rise. If rates were to escalate, then, and you own a sizable amount of bonds, particularly long-term bonds, the value of your portfolio could show a noticeable decline. Should you be worried?
Actually, no matter where interest rates go, you can gain some key benefits from owning bonds. Specifically, assuming your bonds are not called, you’ll receive the same amount of income, based on your bond’s interest rate, and you’ll get your principal 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 result, you should prepare your bond portfolio for changes in interest rates.
Of course, in the past few years, interest rates have been at or near historic lows. 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. This 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 if they rise.
No one can really predict what interest rates will do. 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 Reserve has historically increased interest 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, interest rates could rise without any action 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. That’s particularly true if inflation expectations 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? One strategy is to create a “ladder” of bonds of varying maturities. A bond ladder can provide advantages in all interest-rate environments. 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 proceeds 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.