It took awhile, but the Federal Reserve followed up its December 2015 interest rate increase with another quarter-point hike in December 2016. And they are thought to be planning two-to-three more hikes in 2017. While nothing is set in stone—especially with a new administration in place—a year of rising interest rates is the general expectation.
What we are hearing
I wrote about this issue a year ago and explained why slowly rising rates are not a cause for worry. But concern is still being expressed, especially in the financial media. So I’d like to go into a little more detail about how we handle a rising rate environment.
The Back Story
First of all, you probably understand how to deal with interest rate changes when it comes to your home mortgage. When rates fall, you want to refinance into a new mortgage to benefit from the new (lower) rate. When rates rise, you want to stay with your existing mortgage.
When you invest in bonds, it’s the opposite. You’re the lender instead of the borrower. When rates fall, you’d like to stay with your existing bonds. When rates rise, you would rather trade in your existing bonds for new (higher rate) ones.
Unfortunately, it’s not that simple. Bonds have a maturity date at which the bondholder receives his principal back as well as any interest still due. If you want to get your money out of a bond before it matures, you have to sell the bond to someone else. And why would anyone buy your old bond if they can get a new one paying a higher rate?
They wouldn’t, unless you make the bond you are holding attractive to the prospective buyer by agreeing to sell it for less than you paid.
For instance, suppose you buy a $1,000 bond that matures in a year. It pays simple 5% annual interest. So after one year you’ll receive your $1,000 back plus $50 interest. But now suppose that immediately after you buy it, the interest rate on new bonds rises to 10%.
You might like to sell your 5% bond and reinvest that $1,000 in one of the new bonds that pays 10%. But your 5% bond is now only worth $954.50 to a new buyer. That is the price that an investor would have to pay for a $1,000 bond with a 5% interest rate to yield a 10% return on their investment—in other words, to get the same return they could get from a new bond offering 10%.
And that is how a rise in interest rates makes the value of your existing bonds fall. The alternative to selling them at a loss is to hold them to maturity, at which time you will receive the full amount of the principal back. Then you can reinvest that money in new (higher rate) bonds.
What You Should Do
So the best strategy, in times of rising rates, is to buy bonds with relatively short maturities.
The time to a bond’s maturity is called its “duration.” At present, I recommend bonds with durations no longer than two-to-five years. That makes it easier to hold them to maturity, then reinvest in new (higher rate) bonds. In this way, rising rates work in your favor.
It’s also important to be well diversified between bonds and other assets such as stocks. If rising rates lower the value of your bonds, stocks may increase and create an offset. It’s all about keeping you in control, reducing risk and making the road to your financial goals feel smooth, even when there are bumps along the way.
To learn more, please contact me, Jeff Riley, CFP, CLU at 713.964.4028 or firstname.lastname@example.org.