Good Investments
that are Right for You

360_F_108990747_irlo8ZueGzBDZL82YhS3FuC5h0MJhAyF

Managing Bond Risks When Interest Rates Rise

After dropping the benchmark federal funds rate to a rock-bottom range of 0%–0.25% early in the pandemic, the Federal Open Market Committee has begun raising the rate toward more typical historical levels in response to high inflation. At its March 2022 meeting, the Committee raised the fund’s rate to 0.25%–0.50% and projected the equivalent of six more quarter-percentage-point increases in 2022 and three or four more in 2023.¹

Raising the federal funds rate places upward pressure on a wide range of interest rates, including the cost of borrowing through bond issues. Regardless of the rate environment, however, bonds are a mainstay for investors who want to generate income or dampen the effects of stock market volatility on their portfolios. You may have questions about how higher rates could affect your fixed-income investments and what you can do to help mitigate the effect on your portfolio.

Rate Sensitivity

When interest rates rise, the value of existing bonds typically falls, because investors would prefer to buy new bonds with higher yields. In a rising rate environment, investors may be hesitant to tie up funds for a long period, so bonds with longer maturity dates are generally more sensitive to rate changes than shorter-dated bonds. Thus, one way to address interest rate sensitivity in your portfolio is to hold short and medium-term bonds. However, keep in mind that although these bonds may be less sensitive to rate changes, they will generally offer a lower yield than longer-term bonds.

A more specific measure of interest-rate sensitivity is called duration. A bond’s duration is derived from a complex calculation that includes the maturity date, the present value of principal and interest to be received in the future, and other factors. To estimate the impact of a rate change on bond investment, multiply the duration by the expected percentage change in interest rates. For example, if interest rates rise by 1%, a bond or bond fund with a three-year duration might be expected to lose roughly 3%
in value; one with a seven-year duration might fall by about 7%. Your investment professional or brokerage firm can provide information about the duration of your bond investments.

If two bonds have the same maturity, the bond with a higher yield will typically have a shorter duration. For this reason, U.S. Treasuries tend to be more rate sensitive than corporate bonds of similar maturities. Treasury securities, which are backed by the federal government as to the timely payment of principal and interest, are considered lower risk and thus can pay lower rates of interest than corporate bonds. A five-year Treasury bond has a duration of less than five years, reflecting income payments received prior to maturity. However, a five-year corporate bond with a higher yield has an even shorter duration.

When a bond is held to  maturity, the bond owner would receive the face value and interest, unless the issuer defaults. However, bonds redeemed prior to maturity may be worth more or less than their original value. Thus, rising interest rates should not affect the return on a bond you hold to maturity, but may affect the price of a bond you want to sell on the secondary market before it reaches maturity.

Bond Ladders

Owning a diversified mix of bond types and maturities can help reduce the level of risk in the fixed-income portion of your portfolio. One structured way to take this risk management approach is to construct a bond ladder, a portfolio of bonds with maturities that are spaced at regular intervals over a certain number of years. For example, a five-year ladder might have 20% of the bonds mature each year.

Bond ladders may vary in size and structure and could include different types of bonds depending on an investor’s time horizon, risk tolerance, and goals. As bonds in the lowest rung of the ladder mature, the funds are often reinvested at the long end of the ladder. By doing so, investors may be able to increase their cash flow by capturing higher yields on new issues. A ladder might also be part of a withdrawal strategy in which the returned principal from maturing bonds provides retirement income.

In the current situation, with rates projected to rise over a two to three year period, it might make sense to create a short bond ladder now and a longer ladder when rates appear to have stabilized. Keep in mind that the anticipated path of the federal funds rate is only a projection, based on current conditions, and may not come to pass. The actual direction of interest rates might change.

Laddering ETFs and UITs

Building a ladder with individual bonds provides certainty as long as the bonds are held to maturity, but it can be expensive. Individual bonds typically require a minimum purchase of at least $5,000 in face value, so creating a diversified bond ladder might require a sizable investment. Diversification is a method used to help manage investment risk; it does not guarantee a profit or protect against investment loss.

A similar approach involves laddering bond exchange-traded funds (ETFs) that have defined maturity dates. These funds, typically called target-maturity funds, generally hold many bonds that mature in the same year the ETF will liquidate and return assets to shareholders. Target maturity ETFs may enhance diversification and provide liquidity, but unlike individual bonds, the income payments and final distribution rate are not fully predictable.

Another option is to purchase unit investment trusts (UITs) with staggered termination dates. Bond-based UITs typically hold a varied portfolio of bonds with maturity dates that coincide with the trust termination date, at which point you could reinvest the proceeds as you wish. The UIT sponsor may offer investors the opportunity to roll over the proceeds to a new UIT, which typically incurs an additional sales charge.

Bond Funds

Bond funds — mutual funds and ETFs composed mostly of bonds and other debt instruments — are subject to the same inflation, interest rate, and credit risks associated with their underlying bonds. Thus, falling bond prices due to rising rates can adversely affect a bond fund’s performance. Because longer-term bonds are generally more sensitive to rising rates, funds that hold short- or medium-term bonds may be more stable as rates increase.

Bond funds do not have set maturity dates (with the exception of the target maturity ETFs discussed above), because they typically hold bonds with varying maturities, and they can buy and sell bonds before they mature. So you might consider the fund’s duration, which takes into account the duration of the underlying bonds. The longer the duration, the more sensitive a fund is to changes in interest rates. You can usually find duration with other information about a bond fund. Although helpful as a general
guideline, duration is best used when comparing funds with similar types of underlying bonds.

A fund’s sensitivity to interest rates is only one aspect of its value — fund performance can be driven by a variety of dynamics in the market and the broader economy. Moreover, as underlying bonds mature and are replaced by higher-yielding bonds in a rising interest rate environment, the fund’s yield and/or share value could potentially increase over the long term. Even in the short term, interest paid by the fund could help moderate any losses in share value.

It’s also important to remember that fund managers might respond differently if falling bond prices adversely affect a fund’s performance. Some might try to preserve the fund’s asset value at the expense of its yield by reducing interest payments. Others might emphasize preserving a fund’s yield at the expense of its asset value by investing in bonds of longer duration or lower credit quality that pay higher interest but carry greater risk. Information on a fund’s management, objectives, and flexibility in meeting those objectives is spelled out in the prospectus and also may be available with other fund information online.

The return and principal value of individual bonds, UIT units, and mutual fund and ETF shares fluctuate with changes in market conditions. Fund shares and UIT units, when sold, and bonds redeemed prior to maturity may be worth more or less than their original cost. ETFs typically have lower expense ratios than mutual funds, but you may pay a brokerage commission whenever you buy or sell ETFs, so your overall costs could be higher, especially if you trade frequently. Supply and demand for ETF shares may cause them to trade at a premium or a discount relative to the value of the underlying shares. UITs may carry additional risks, including the potential for a downturn in the financial condition of the issuers of the underlying securities. There may be tax consequences associated with the termination of the UIT and rolling over an investment into a successive UIT. There is no assurance that working with a financial professional will improve investment results.

1) Federal Reserve, March 16, 2022

© Broadridge, Inc. – article posted with permission.

Other Recent Articles

Traced Act Offers Consumers Additional Protections Against Robocalls

Whether at home, work or on a cell phone, it's a scenario many Americans have found themselves in: answering a phone call only to find out it's from an unwanted robocaller. In fact, the number of unwanted robocalls in this country has skyrocketed in recent years. The Federal Communications Commission (FCC) ranks unwanted robocalls highest on their list of consumer complaints.

IRS Increases Standard Mileage Rates for Last Half of 2022

Due to recent increases in the price of fuel, the IRS has increased the optional standard mileage rates for computing the deductible costs of operating an automobile for business, medical, and moving expense purposes for the second half of 2022. The standard mileage rate for computing the deductible costs of operating an automobile for charitable purposes is set by statute and remains unchanged. For July 1, 2022, to December 31, 2022, the standard mileage rates are as follows
man and woman looking at social secuity paperwork

Social Security’s Uncertain Future: What You Should Know

Social Security is a pay-as-you go system, which means today's workers are paying taxes for the benefits received by today's retirees. However, demographic trends such as lower birth rates, higher retirement rates, and longer life spans are causing long-run fiscal challenges. There are simply not enough U.S. workers to support the growing number of beneficiaries. Social Security is not in danger of collapsing, but the clock is ticking on the program's ability to pay full benefits.

Other Articles Related to:

man and woman looking at social secuity paperwork

Social Security’s Uncertain Future: What You Should Know

Social Security is a pay-as-you go system, which means today's workers are paying taxes for the benefits received by today's retirees. However, demographic trends such as lower birth rates, higher retirement rates, and longer life spans are causing long-run fiscal challenges. There are simply not enough U.S. workers to support the growing number of beneficiaries. Social Security is not in danger of collapsing, but the clock is ticking on the program's ability to pay full benefits.

IRS Increases Standard Mileage Rates for Last Half of 2022

Due to recent increases in the price of fuel, the IRS has increased the optional standard mileage rates for computing the deductible costs of operating an automobile for business, medical, and moving expense purposes for the second half of 2022. The standard mileage rate for computing the deductible costs of operating an automobile for charitable purposes is set by statute and remains unchanged. For July 1, 2022, to December 31, 2022, the standard mileage rates are as follows

High Inflation: How Long Will It Last?

In March 2022, the Consumer Price Index for All Urban Consumers (CPI-U), the most common measure of inflation, rose at an annual rate of 8.5%, the highest level since December 1981. It's not surprising that a Gallup poll at the end of March found that one out of six Americans considers inflation to be the most important problem facing the United States. When inflation began rising in the spring of 2021, many economists, including policymakers at the Federal Reserve, believed the increase would be transitory and subside over a period of months. One year later, inflation has proven to be more stubborn than expected. It may be helpful to look at some of the forces behind rising prices, the Fed's plan to combat them, and early signs that inflation may be easing.