During times of rising interest rates, you’ll get greater control—and more peace of mind—
by focusing on individual bonds and bond ladders.
Around 1980, the mortgage rate on my first home loan was 16%. Then began a 30-year downward trend that didn’t begin to reverse course until earlier this year. Although average mortgage rates still sit under 5%, the rate is expected to climb.
Rising interest rates were triggered earlier this year with a bump up in the federal funds rate to offset inflationary pressures (see Short-term borrowing rates inch higher). The Federal Reserve is primed to step up interest rates to keep inflation in check as the economy continues to do well.
As interest rates climb, bond prices fall. What does this mean for your bond investment strategy? Shift your strategy to invest in individual bonds rather than bond funds, giving you greater control and peace of mind as interest rates rise. This way should fund values drop quickly, you won’t get caught owning the wrong assets.
Shifting away from bond funds
Whether you’ve made it a practice to purchase bonds individually, in a mutual fund that invests in bonds (bond fund), or a combination of the two, it’s likely time to adjust your strategy. Bond funds generally are more interest rate sensitive, making them more volatile in a rapidly rising interest rate environment.
Bond funds don’t have a maturity date, which puts your principal at risk (see sidebar). Bond funds rarely hold bonds to maturity and investors can lose some or all their initial investment in a bond fund. The faster interest rates rise, the more panicky bond fund investors–who do not have the option of holding their fund assets to maturity and recouping principal–become.
You’ll also be paying more to put yourself into a riskier bond strategy that may struggle to stay ahead of inflation. Investment grade bond funds have an expense ratio of 0.9%, according to Morningstar.
Individual bonds
If bonds are part of your overall investment strategy, stick to individual bond investments during rising interest rate environments. Hold them to maturity to get interest and principle back. Individual bonds and bond ladders can offset the impact of rising rates, preserving the safety and income you’ve come to expect from your bond investments.
Even if interest rates rise rapidly, you’ll have greater control and peace of mind with a portfolio of individually held, timed, and selected bonds than a professionally managed, costlier bond fund. This direct control gives you greater opportunities to shift strategies when the time is right.
Diversify individual bond investments to reduce your default risk. Larger investors can select and hold enough individual bonds to make up a diversified portfolio. Smaller investors without sufficient funds to self-diversify can buy into a group of bonds packaged up individually known as a unit investment trust.
Regardless of how you diversify, make sure you’re investing in investment grade bonds of high-quality issues.
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Why maturity matters
Individual bonds pay out at a fixed rate of return when held to maturity. The income is generally fixed and maturity date set at the time of purchase.
Investors actively manage individual bonds and look to diversify across different issuers. You can sell individual bonds before the maturity date at a gain or loss.
Much of the complexity in buying individual bonds is tied to quantifying costs, understanding bond characteristics, and timing maturity to maximize the tax treatment, cash flow and reinvestment of the proceeds.
Bond funds are a professionally managed portfolio of bonds marked-to-market each day. These are popular among investors that want diversification and lower default risk without having to track individual bond performance.
Bond fund values don’t move in the same way as individual bonds because of maturity dates. Most funds hold thousands of bonds with different maturities, yields and durations. When you sell shares in a fund, you receive the fund’s current net asset value (NAV)–the value of fund holdings divided by fund shares less the redemption fee.
Individual holdings in a bond fund are constantly maturing. This allows bond fund managers to reinvest maturing proceeds at higher rates when interest rates are rising, offsetting some of the downside risk.