Gravity doesn’t just apply to apples and sky divers, you know. The same “what goes up, must come down” concept can also be applicable to the bond market, where elevated prices have generally boosted fixed income returns for several years. Interest rates probably won’t remain near historic lows. And because yields move inversely to bond prices, that means the latter is unlikely to stay at high levels indefinitely. Why? For starters, the U.S. economy appears to be finally stepping on the gas pedal after years of sluggish job growth.
All Things Considered
There’s much we don’t know. How quickly and widely the global economy will continue to recover from a wrenching recession is anyone’s guess, although we can point to evidence that, in the U.S., housing, consumer spending and the job market seem to have turned the corner. In June, the U.S. unemployment rate fell to 6.1%, the lowest since September 2008, according to the Labor Department. Meanwhile, interest rate guideposts, such as the 10-year Treasury bond yield, have ticked higher from spring lows (see figure 1).
What we do know: interest rates can fluctuate regardless of actual changes to Federal Reserve monetary policy. Earlier this year, the Fed began scaling back one of its major economic stimulus initiatives, the so-called QE bond purchases. By the end of the year, QE is expected to be over. That still leaves the question of when the Fed will hike its benchmark funds rate, which has remained at 00.25% snce late 2008, when the central bank was grappling with a global financial crisis.
This is a critical item for investors, because the Fed funds target is linked to nearly every other fixed income rate. Many analysts expect Janet Yellen and crew to boost rates in summer 2015. How will the markets respond? You have to go back to June 2006 for the previous Fed hike, which lifted the funds target to 5.25%. Conditions were obviously much different back then. Whatever the outlook, investors need to prepare for eventual change.
If interest rates go up and you need to sell your bonds before they mature, you need to be aware their value may have gone down and you may have to sell at a loss. If you buy a bond and hold onto it until it matures, which many investors do, rising rates won’t change the income payments you receive. At maturity, you get back par, which is the face value of the bond. But don’t forget about credit or default risk, the risk that an issuer can’t honor its principal and interest payment obligations.
Not One Size Fits All
Of course, as the Securities Industry and Financial Markets Association (SIFMA) points out, changes in interest rates don’t affect all bonds equally. Generally speaking, the longer the bond’s maturity (for example, a bond that matures in 10 years versus another that matures in two), the greater the impact of changing interest rates.
A 10-year maturity will usually lose more of its value if rates go up than a 2-year note because of its longer exposure, or duration. Also, the lower a bond’s “coupon” rate, the more sensitive the bond’s price is to changes in rates. Coupon denotes the amount of interest due, and when. Other features can have an effect as well. For example, a variable-rate bond probably won’t lose as much value as a fixed-rate security. Certainly, there may be other key differences that set your particular bond apart. Read more at SIFMA’s Investinginbonds.com.
There’s more to think about. For instance, what type of fixed income investment do you hold? Individual bond holdings stand to lose value in a rising-rate environment. And, bond mutual fund holders must keep in mind that their exposure may be less obvious, considering there’s no stated maturity to the holdings in a fund. Investors in fixed income exchangetraded funds must also pay attention to liquidity, a key supportive factor for ETFs, which trade on an exchange like a share of stock.
“Investors may be tempted to stretch for yield in this low interest rate environment,” said Craig Laffman, Director, Fixed Income Trading & Syndicate, at TD Ameritrade. “It is more important than ever to understand the characteristics of the fixed income holdings in your portfolio. It is not a question of if rates will rise, but when. Investors need to understand the potential ramifications associated with taking on additional credit or maturity risk of the underlying investments as well when rates finally start to rise. The excess return generated may not be worth the additional risk incurred.”
A Place In Your Portfolio
There’s a key objective inherent in the fixed income category of investing— that is, income (hey, it’s right there in the name). This means bond holdings in all forms (U.S. Treasuries, corporate bonds, munis, global debt, agencies, mortgage-backed securities, structured products, brokered CDs, fixed income mutual funds and ETFs) will continue to be an important part of a diversified portfolio.
But, as with any investment, there can come a time when risks once considered in the abstract may become reality. Preparation is key. Keeping an eye on the long-term horizon and seeking guidance from a fixed income professional can help keep you on solid ground even as the market landscape shifts.
Carefully consider the investment objectives, risks, charges, and expenses of an exchange traded fund before investing. A prospectus, obtained by calling 800-669-3900, contains this and other important information about an investment company. Read carefully before investing.