A Brief “Bond Investing 101” in Anticipation of Rising Rates

An old acquaintance of mine came out of woodwork recently and asked if I would write about what ardent bond investors should be doing now that we’re likely on the cusp of a predominant climate of rising interest rates. No problem. Let me say here at the outset that I’m making two assumptions with respect to this article: You’re not a more sophisticated or astute investor, in which case you’d already likely know, at least generally, what you should be doing, and that you are someone who wants to remain primarily in bonds.

A quick summary, first, regarding rate movement and bond prices – rising rates are generally bad for bond investors, just as climates in which rates are falling are good for bond investors. Let’s illustrate why this is (the numbers quoted here exist simply as examples): If you own a bond paying 6%, then as rates decrease…5%, 4%, and lower…your bond paying 6% becomes more valuable to someone who wants a bond paying that rate, which is now much higher than the prevailing rates at
which new bonds are being issued. However, as interest rates rise…back up to 5%, past your 6%,say to 8%…then conditions comes to exist wherein a new bond buyer is better off purchasing freshly-issued bonds at those prevailing rates. As a consequence, your 6% bond is now less attractive, and so in order to get anyone to buy it, you have to sell it at a discount; the only way to recover the full principal in such an environment at that point would be to hold the bond to maturity. This is a simplified explanation of how the mechanics of this work, but it is functional for the purposes of this article.

Now, then, as a bond investor in the present market, where interest rates are, by all accounts, expected to begin moving upward in the not-too-distant future, it’s important to have some idea as to how you will negotiate these choppy waters and still keep your hand in bonds.

If you own individual bonds…

…think about weeding out those issues in your bond portfolio with longer maturities, particularly those with maturities beyond ten years – in a climate of rising rates, the longer the bond maturity, the greater the damage. Additionally, think about creating a bond “ladder” with the rest of your bond-dedicated assets to help make the best of the interest rate situation. With a bond ladder, an investor purchases several bonds of varying maturities…ranging from, say, six months to maybe five-seven years, but not too far out, as long as the move upward appears to remain actively in motion. As soon as one bond matures, the investor takes the proceeds from that bond and buys a new, longer-term bond that has been issued at the higher, prevailing rates. The reason you would include any bonds with maturities as far out as several years at the time you initially construct your ladder is out of deference to, as much as possible, hedge your bets and maintain an overall diversified portfolio of debt securities. That is, in the volatile economy that now serves as our constant companion, the movement of rates is not entirely easy to predict, so while you want to make appropriate moves on behalf of a suspicion that rates will go higher, keeping some of your money in more medium-term debt securities keeps your hand in instruments with better interest should rates stabilize or even dip back down. Ultimately, a ladder is a way to lower your direct exposure to interest rate risk, specifically, but it does not eliminate it entirely. If you own bonds individually, by all means get with your financial advisor and see if your portfolio is in need of a
laddering strategy.   

Something else to consider is taking a portion of your money and directing into Treasury Inflation-Protected Securities, or TIPS. TIPS are issued by the U.S. Treasury and are government bonds with a bit of a twist; while the coupon rate (think: interest rate your bond pays) remains the same, the principal amount of TIPS is indexed to inflation, specifically through the Consumer Price Index, or CPI. When the CPI rises, the principal amount rises, and so then do the interest payments, because the coupon rate is now calculated against a higher principal. Note, however, that the mechanism works in reverse – when rates decrease, so does the principal value of your TIPS, so they are really
something to use at a time when rates are expected to move up.      

If you own bond funds…

…which is the way a LOT of people own bonds these days…then you want to know two things about your bond fund(s): the duration, and the average maturity. Duration, in this case, is not a measure of time, but a measure of how interest rate-sensitive the bond fund share price is to possible interest rate changes. If the duration of a bond fund is 2, then it is said that a 1 percentage point rise in rates will see the share price fall 2% (and in a climate wherein interest rates drop by 1 point, the value of the share price would increase by 2%); again, if duration is 2, and rates rise or fall by 3
percentage points, then your share price will decrease (in rising rates) or increase (in falling rates) by 6%. In other words, to use duration as a guideline, you will multiply the duration of the fund by a prospective percentage point movement in rates, one way or another, to see how that movement will impact the share price of your fund.    

Average maturity, as the term implies, refers to the average maturity of the individual bonds that comprise the underlying portfolio, and as with individual bonds, the longer the maturity, the more risk to the bond holder. Very simply, your strategy here as a bond fund investor is to reconfigure your holdings to reflect both lower duration and lower average maturity funds. This will, of course, impact whatyou realize in interest, but it’s an important move on behalf of capital preservation, which is hugely important to folks whose portfolios are made up mostly (or entirely) of bonds, anyway .      

When rates appear that they’re on the move upward, it’s time for bond investors to get proactive with their holdings, which is a feature that is not typically characteristic of their investing habits. Still, in order to put yourself in the best possible position as a bond investor, you have to be willing to get in front of this activity. One last thing: before making any changes to your portfolio, be sure to consult your financial advisor.   

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