When Federal Reserve Chairman Ben Bernanke talks about interest rates, the U.S. financial markets pay close attention. In his recent testimony to Congress, Bernanke said the Fed will continue to focus on stimulating the economy by keeping rates low.
But growing concerns about a future change in monetary policy by the Fed have scared many fixed-income investors. If interest rates rise, the values of fixed-income bonds tend to fall. If you’re holding bonds in your diversified investment portfolio, there’s no reason to panic.
Bond holders should be more concerned about the possibility of default, an unlikely but not impossible occurrence, than with the fluctuations in the value of their fixed-income securities. After all, interest rates have been at historical lows for several years, and investors should realize that rates will be going up eventually.
Here is a basic example of how bonds work. If an investor buys a bond that matures in 10 years for $1,150 (at a premium-$150 above par) it pays interest of 5 percent per year. The investor receives $50 annually. When the bond matures, the investor receives $1,000 (par).
Therefore, if an investor decides to sell bonds at a loss in response to interest rates rising with the understanding they will mature at par makes very little sense. That investor should have never owned the bonds in the first place. It’s no different than panic selling after the stock correction had already taken place.
That’s because many investors don’t understand how bonds work and the role they can play in a diversified portfolio of assets.
First, bonds can help cushion the volatile ups and downs of the U.S. stock market, an important advantage for investors who want to sleep well at night. Bonds also help to reduce the volatility of an overall portfolio because they have a low correlation to other asset classes.
Second, bonds can generate a steady stream of income. That’s a particularly important consideration for retirees who depend on those payments to help pay their ongoing living expenses.
Even if the value of the bond goes up or down, there is no change in income from that bond — a fact that many investors fail to recognize. So, if you are holding bonds in your portfolio to generate income, selling them at a point when their values have gone down is overreacting to the financial headlines.
Companies, municipal governments and public agencies issue fixed-income bonds to finance projects, raise working capital or fund a growth strategy. Because these securities are a form of debt, bonds are graded on the basis of the issuer’s credit-worthiness. Investment-grade bonds are the most highly rated, because there is relatively little risk of a default.
For some investors with high incomes, municipal bonds make sense because their returns are generally exempt from federal and state income tax. That means a municipal bond paying 3 percent free and clear of taxes might be a better buy than a corporate bond paying 4.5 percent if the investor is in a high tax bracket.
In general, income from investment-grade bonds are generally lower than the income generated by high-yield bonds, which have higher payments because there is a greater risk of default. Since each investor has different objectives and tolerance for risk, it’s important to discuss these types of investment issues with your financial advisor.
At a certain point in time, usually from one year to 30 years after issuance, the bond matures and the investor receives the par value of that investment. Of course, inflation can take a big bite out of a bond’s purchasing power and a $1,000 fixed-income security issued today might be only able to buy $500 in goods and services in 20 to 25 years.
Therefore, bond values are very sensitive to changes in inflation and the accompanying changes in interest rates. One effective strategy for reducing those risks is building a “bond ladder” with securities that mature at different dates. If interest rates rise over the next few years, as is likely to be the case, you would have bonds maturing periodically. You would be able to reinvest at potentially higher rates.
That helps reduce the risk of inflation, while retaining the stabilizing benefits of bonds in your portfolio.
While it’s important to keep track of the Federal Reserve’s actions in regard to monetary policy, don’t let those changes drive your bond investment decisions. Take a deep breath and think about your long-term goals before shifting your asset allocations.
Andrew Menachem, CIMA, is a Wealth Advisor at the Menachem Wealth Management Group at Morgan Stanley in Aventura and teaches at the University of Miami. Views expressed are those of the author, not necessarily Morgan Stanley, and are not a solicitation to buy or sell any security. The strategies and/or investments referenced may not be suitable for all investors.