Should I still hold bonds in my portfolio while there continues to be talk of the Fed raising interest rates?
In June the Federal Reserve, commonly referred to as the Fed, raised interest rates for the second time in 2018. During the announcement, the Fed also indicated rates may rise another two times before the year is over. While generally a signal that the economy is strengthening, it also means that rates on credit cards, home equity loans, and other types of borrowing will increase. Another common side effect of rising interest rates is that the price of existing bonds and bond funds generally fall. Many investors own bond positions as part of their diversification strategy; therefore, it is important to understand how rising interest rates may affect investment portfolios.
Individual bonds, bond mutual funds, and exchange-traded funds react differently to rising interest rates. Individual bonds pay a stated interest rate until they mature so, when held to maturity, investors are spared the impact of price fluctuations caused by rising interest rates. However, if investors want to sell a bond before its maturity, they may have to do so at a discount. Why? Now that interest rates have increased, potential buyers can purchase that same face-value bond on the open market and receive a higher interest rate. To entice buyers to purchase your (now) less valuable bond, you must offer it at a discount with still no guarantee you can sell it.
Changes in interest rates don’t affect all bonds equally either. Generally speaking, the longer the bond’s maturity, the more it’s affected by changing interest rates. For example, a bond that matures in 20 years will usually lose more of its value if rates go up than another bond that matures in 5 years. Also, the lower a bond’s “coupon” rate, the more sensitive its price is to changes in interest rates. For example, a bond with a coupon rate of 3% will experience more price fluctuation than a bond with a coupon rate of 5%.
The lower the coupon rate, with all other things being equal, the less valuable the bond is and the bigger the discount that needs to be applied if the intention is to sell the bond.
Bond mutual funds and exchange-traded funds react a little differently to rising interest rates than individual bonds. Since a bond fund doesn’t have a specific maturity date, often the fund’s total return will go down. Total return encompasses both change in prices and interest rate payments. If interest rates rise, the values of bonds held by the fund fall, negatively affecting total return. However, the fund continues to receive interest payments from the bonds it holds and will pass those along to investors regularly, maintaining current yield.
Even in a rising-rate environment, owning bond funds may make more sense to some investors. For example, bond funds tend to offer greater ability to sell at a given price, if you need to, on any given day, and more diversification relative to individual bonds.