If you’ve been socking away cash in bonds, assuming they are risk-free investments, you may be in for a surprise. In March, the Federal Reserve raised the federal funds rate — which influences interest rates across the board — and signaled that it intends to continue raising rates over the coming year, which could lead to losses for bond investors.
A new survey from BlackRock found that nearly one-third (31 percent) of investors believe “you can’t lose your money” with fixed income investing. But in reality, rising interest rates actually have a negative impact on bond prices, so it is possible to lose money on the bonds in your portfolio if interest rates continue to rise.
“A lot of people think because they’re getting their principal investment back at the end of the bond’s duration, they’re not losing money,” says Don Riley, chief investment officer at Wiley Group in Conshohocken, Pa. “But because of inflation, the principal is worth less when you take it out than when you put it in, so you are losing money if that investment could be earning more in another vehicle.”
How Interest Rates Affect Bonds
As interest rates rise, bond prices fall “since the present value of the income and principal payments are worth less,” says Karen Schenone, CFA, fixed income strategist within BlackRock’s Global Fixed Income Group. “For example, if you own a bond priced at $100 with a coupon of 3 percent and then interest rates increase to 4 percent, you now own a bond that is paying less than the current market rate.”
When interest rates increase, the current value of your bond holdings will drop to reflect the fact that the income the bonds pay is less than the current market rate. If you hold your bond to maturity and the issuer pays the coupons and principal on time, then the bond will mature back at your principal rate, so you won’t technically lose money — but due to inflation, your $100 will be worth less than it was when you invested it.
What to Do Now
Just because rates are rising, that doesn’t mean you should completely stay away from bonds. But you may want to adjust your strategy to account for lower earnings.
“Bonds play a critical role in investors’ portfolios as a source of stability and income,” Schenone advises. “A common mistake that investors make is abandoning bonds when they think interest rates may increase. For any investor, time in the market is more important than trying to time the market.”
In the current environment, bond investors should look for shorter term bonds, says Eric Aanes, president of Titus Wealth Management in Larkspur, Calif. He recommends durations under two years. “If you have a bond with five-year duration and interest rates go up on the 10-year duration bonds, you would lose five percent,” Aanes says.
In addition to looking for shorter terms, consider investing in bond funds rather than individual bonds, Riley recommends. “When you’re in a bond fund, the yield is slowly rising over time because of portfolio changes and bonds rolling out over time,” Riley says. “Bond funds act like a bond ladder, so when one matures, others are still going.”
And even though bonds aren’t strictly risk-free, increasing interest rates can offer advantages.
“Rising rates mean that you could now reinvest the coupon payments or principal payments at higher rates,” Schenone says. “So if you are a long-term investor, higher rates mean that you can now reinvest your proceeds into a higher yielding bond, which can boost income and can potentially offset the price loss over time.”