Interest rates will head higher eventually, which in turn will depress bond prices. This development could be a nasty one for investors since rates have been ultra-low since the financial collapse of 2008. But now is the time to start thinking about how to take action to protect the value of your bond portfolio.
Bonds Don’t Value Rising Rates
Investors who have seen the value of their bond portfolios rise in an ultra-low rate environment are likely to get a rude awakening when they are faced with the effects of rising interest rates.
There is a real danger to bond yields from rising rates, because as new bonds are issued at higher coupons, existing, fixed-coupon bonds fall in value.
When this happens, some bondholders will be tempted to sell off – but turning away from the bond market isn’t the only option .
So What’s an Investor To Do?
“Investors in a volatile interest rate environment need to understand what ‘duration’ is and how it can devastate their fixed income holdings,” said Peter McGann, wealth advisor at McGann Wealth Management in Ottawa.
McGann believes it is crucial that investors find money/portfolio managers with a track record of working in high and low interest rate environments and increasing/declining yield markets.
He said they also need to understand the correlation with economic growth/decline and positive/negative fiscal and monetary policy, .
“Managers need to be able to assimilate these factors and make decisions on how, when, where to invest,” McGann added.
There are a few things that the savvy investor can do to avoid unpleasant surprises like falling bond prices.
Floating rate bonds are an attractive option because they don’t fall in value with rising rates like their conventional fixed-rate cousins.
Analysts say that since their interest payment moves up with interest rates, this makes them the best choice for a rising rate environment.
Of course, there is a catch since the obvious problem for floating rate bonds is declining interest rates.
Confining your portfolio to shorter term instruments will also provide some protection. That’s because the shorter the term of a bond, the less a bond will fall with rising interest rates.
When interest rates are rising, the better it is to “roll over” the portfolio. That means short-term bonds or T-Bills that will mature quickly and be reinvested at higher interest rates are much less exposed to higher rates than long-term bonds.