Some of you may be wondering what will happen to my bonds when interest rates go up?
The answer is pretty simple.
It doesn’t matter if they are munis, treasuries or corporates, when interest rates start to rise, bond prices will fall. You have to think about it this way. Let’s say you own a bond paying 5%. A new bond comes to the market after rates rise. The new interest rate on bonds coming out is 5.5%. Which bond is more valuable? Wouldn’t you rather get paid 5.5% than 5%? Of course you would. On the flip side, that makes the lower interest paying bond less valuable. My illustration below will help you visualize my example.
You still get paid.
You will still receive the 5% interest no matter what happens to the price of the bond. Think of the bond as a dairy cow. The dairy cow is worth different values on any given day, right? That’s the price of the bond which fluctuates all the time. The milk (the interest paid) is produced no matter what the price of the cow. Now if you hold the bond to maturity, you really shouldn’t care about the price of the cow, uh, bond on any given day.
What higher rates really mean.
If you own bonds then you will see the value decrease on your statements. As rates inch higher, the bleeding will continue and maybe even intensify. If you are a long-term investor then it really doesn’t matter. You will keep these bonds for diversification sake. So you will see some red as rates rise. Again, on the flip side, higher rates mean better rates on new bonds, CDs and savings accounts.
What can an investor do?
It really depends on your goals. If you are a long-term growth investor, you probably could just sit tight. If you are taking income from your bonds, this might be a great opportunity to pick up a few that would increase your income. Regardless, both types of investors could make some small adjustments to their bond portfolios. You could avoid long-term bonds. Longer term bonds will have a more severe reaction to a rise in interest rates. You may even look into treasury inflation protected securities (TIPS). They adjust their interest rates up as rates rise. There are multiple strategies available to help you in this coming environment.
There are lot more things and investor can do, but talk to your financial advisor first. If you want a second opinion I’d be happy to help. If you found my article helpful, please subscribe here for FREE! I’ll toss my articles in your inbox every Friday.