Rising interest rates can cause problems for fixed income investors. One of the basic concepts of bond investing is the inverse relationship that exists between interest rates and bond prices. As interest rates rise, bond prices normally fall. Rates mean that the prices of existing bonds offering lower rates must drop to attract buyers. For example, if an investor buys a $5,000 bond with a coupon rate of 5%, but the interest rate offered on the same type of bond rises to 6%, bond buyers will be unwilling to pay the $5,000 original price for those 5% bonds when they can now invest the same amount of money and receive 6% interest. To make the 5% bonds marketable, they must be offered for sale at a discounted price. Investors who already hold the 5% bonds are looking at their investments losing value.
The extent to which rising rates impact specific bonds varies according to the type and maturity of the bonds. Bonds with shorter terms to maturity are generally less affected, since investors will receive their principal back sooner with the opportunity to reinvest at higher rates. Lower-quality bonds that already carry higher yields will also be less affected. The strategies that investors can employ to manage their fixed income investments in a rising rate environment commonly depend on the term to maturity or the yield/risk relationship.
1) Professional Portfolio Management
Bondholders who typically choose and make their own individual bond investments may wish to move more toward investing in professionally managed bond mutual funds or exchange-traded funds (ETFs). Professional bond portfolio managers can often make better or timelier adjustments to the changing rate environment than an individual investor operating on his own might manage.
2) Shorter Maturities
Investors can adjust their bond holdings to bonds of shorter duration. Shorter-term bonds are less susceptible to negative value impacts from rising rates, since interest rates do not generally change significantly over the short term. Bonds with shorter durations afford investors the opportunity to cash in their bonds and reinvest within a shorter span of time, when negative effects from rising rates should be minimal. As rates do gradually rise, investors can regularly reinvest in new bonds offered at higher interest rates.
3) High-Yield Bonds
Because high-yield bonds already offer yields above the average available interest rates, they are less affected by changes in interest rates. Of course, higher yield generally always means higher risk, so investors have to consider the creditworthiness of the issuer and balance the competing forces of risk and reward when choosing bonds. Opting for high-yield bonds can be a very helpful strategy in a rising rate environment, but investors should not violate their own personal risk tolerance levels.
4) Bonds That Perform Best in Rising Rate Environments
Investors can shift their fixed income portfolio assets to certain types of bonds that tend to fare better than average when interest rates are rising. Among the bonds that typically do the best for investors in terms of minimizing risk and generating the best total returns during times of rising rates are Treasury inflation-protected securities (TIPS), premium bonds, and short or ultrashort bond funds. Short bond funds are designed to profit from falling bond prices.
5) Floating Rate Bonds or Bond Funds
Another alternative strategy to use in a rising rate environment is to invest in floating rate bonds or bond funds. The interest rates for floating rate bonds are periodically adjusted, typically somewhere between every 30 to 90 days, in accord with an interest rate benchmark such as the prime rate or LIBOR. These types of bonds often offer somewhat higher yields with minimal additional risk.
Investors must always consider the total picture when making fixed income investments. Beyond simply taking into account Interest rates and available yields, the ultimate focus is a bond's total return on investment (ROI), which includes the interest earned over the time period that the bond is held and any capital gains or losses resulting from any price change in the bond that has occurred between the purchase date and the date when the bond is sold.