Interest rates are at historic lows. They will rise eventually. If you invest in fixed-income vehicles, like bonds, what might higher rates mean for you?
As is the case in the investment world, there’s no simple answer. It’s important to distinguish between short-term and long-term interest rates. The Federal Reserve is determined to keep short-term rates low until unemployment improves. In the meantime, longer-term rates may rise.
A rise in long-term rates can present opportunity and concern. Opportunity: Rising rates can mean greater income if you invest in newly-issued bonds. Concern: If you already own longer-term bonds and rates rise, the value of your bonds will fall. Other investors won’t want to pay full price for your bonds when they can get new ones at higher rates.
If the value of your long-term bonds falls, isn’t it worthwhile to hold on to them? As long as your bond doesn’t default, you’ll get a steady source of income and receive the full value of your bond back at maturity.
They may be more relevant for short-term bonds. Longer-term bonds, of 10-year duration or longer, are more subject to inflation risk than shorter-term bonds. We’ve experienced low inflation for a number of years. Over time, even mild inflation can add up. When this happens, and you own a long-term bond whose rate doesn’t change, you could face a potential loss of purchasing power. One reason that long-term bonds pay higher interest rates than short-term bonds is because the issuers of longer-term instruments are rewarding you for taking on this additional inflation risk.
Simply holding on to long-term bonds — especially very long-term ones — may not be the best strategy. If you review your fixed-income holdings and find that they skew toward longer-term bonds, you may want to consider reducing your exposure in this area. If you sell some of these bonds, you could use the proceeds to build a “bond ladder” — which may be one of the best ways to invest in bonds.
You need to invest in bonds of varying maturities. When market rates are low, you’ll still have your longer-term bonds earning higher interest rates, paying you more income. When market rates rise, you can reinvest your maturing short-term bonds at the higher rates. You must evaluate whether the bonds held within the bond ladder are consistent with your investment objectives, risk tolerance and financial circumstances.
If you own bonds, you need to be aware of where interest rates are — and where they may be headed. You don’t have to be at the mercy of rate movements. Keeping yourself informed and choosing the right strategies, you can benefit from owning bonds and other fixed-income vehicles in all interest-rate environments.
Before investing in bonds, you should understand the risks involved, including credit risk and market risk. Bond investments are subject to interest rate risk such that when interest rates rise, the prices of bonds can decrease, and the investor can lose principal value if the investment is sold prior to maturity.
This article was written by Edward Jones for use by your local Edward Jones Financial Advisor.
Information provided by Karl Ritland, Edward Jones, 1100 N. Hickory Blvd., Suite 201, Pleasant Hill, 266-8188, www.edwardjones.com.