There has been plenty of talk lately about the Federal Reserve raising interest rates. Normally, higher interest rates can be positive for cash savings, but are you aware of how they affect your bonds? Interest rate risk is the risk that arises for bond owners from fluctuating interest rates. How high the risk depends on what type of bonds you have and how sensitive its price is to interest rate changes in the market.
Interest Rates and Bonds
If interest rates rise, the market value of a bond you hold may be reduced. Even though bonds are a fixed-income investment, they are traded just like stocks. Therefore, the overall return you get for your bonds can be influenced by changes in the markets. If your portfolio includes a significant portion of bonds, this can be quite concerning. What are some ways you can reduce interest rate risk and reap the benefits of holding bonds?
Hold on Tight
Interest rate risk can be minimized by holding bonds to maturity and liquidating the bonds to meet income needs. This “buy and hold” strategy gives you interest payments as well as the face value of the bond at maturity. It’s only if you try to sell your bond before maturity that you stand the chance of losing money on the investment.
Check Up On Your Investments
Have you checked on your investments recently? Do they still match your asset-allocation plan? Take an in-depth look at your portfolio and examine how diversified you are. Do you primarily own U.S. Treasury bonds? These tend to be more sensitive to interest rate risk than others. Create a portfolio that has a mix of bonds, such as corporate, global, and short-term, to diversify your risk.
Diversification of bonds works for two reasons. First, when you opt for bonds from a variety of issuers, you have a safeguard against the possibility that one of the issuers of your bond will not be able to pay interest and principal on the investment. Second, when you diversify among different types of bonds, you have a cushion from the potential of losses in any particular market sector. Diversify to keep your bond portfolio as safe as you can.
Bond Ladders and Barbells
Another strategy to minimize interest rate risk is to invest in a bond ladder. This simply means that you invest in bonds with different maturities. When one of your bonds reaches maturity, you roll over your investment into the most current bond issue. In this way, you can take the cash from your bond and pour it into the new bond that has a higher interest rate.
The barbell method is similar in that you invest only in short-term and long-term bonds. The short-term bonds mature sooner, giving you the option to invest your money in other assets if the bond market is struggling, while your long-term bonds will still provide you with fixed-income when they mature.
If you have mature bonds that you want to reinvest, you may want to use a strategy called immunization to offset risk. Immunization locks in a fixed rate of return by adjusting the portfolio duration to match your investment timeline. Immunization gives you a particular rate of return regardless of all the changes in interest rates, making your bonds immune to changes. This plan requires you to rebalance every time interest rates change so that the duration of your investments stay in line with your timeline.
You invest in bonds to guarantee a return and ensure that there will be money to live off of in retirement. Don’t let the inevitable interest rate changes alarm you. There are multiple strategies to eliminate your interest rate risk so that your bonds will help you reach your retirement goals.
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