Interest rates are an important part of everyone’s lives!
Following the 2008 financial crisis, the Federal Reserve (“the Fed”) began to gradually increase key interest rates in December 2015 from a record low of near zero. The expectation is that the Fed will continue raising rates in 2018 and 2019 (See Fed Chart.) On the plus side, this means savers are benefiting from higher yields in CDs, savings, money market funds, treasury bills, etc. On the other hand, borrowers will pay more for loans of all types.
How do interest rate changes affect bonds?
From 1982 until just recently, bonds have enjoyed a long-term decline in interest rates, which pushed bond prices higher. The reason for this is when interest rates fall, bond prices rise; and when rates rise, bond prices fall. Because of this, existing bonds have to be repriced to remain competitive with the yields on new bond issues.
Why should I own bonds?
For investors, to include bonds in their portfolio is essential to reduce overall portfolio risk. Bonds can also give you a stream of income and offset some of the volatility you might see from owning stocks.
What should I do to protect myself against rising rates?
It is possible to measure the impact of rate increases (or decreases). Bond Duration measures a bond fund’s sensitivity to changes in interest rates. The longer the duration, the more a bond funds price will fluctuate when interest rates change.
In an environment of rising interest rates (where we find ourselves currently), the key is not to abandon bonds in a portfolio (we still need balance) but to reduce the duration. One approach would be to have the majority of the bond portfolio in short-term bonds (one- to two-year duration) while maintaining some exposure to intermediate-term bonds (three- to eight-year duration).
A strategy for success!
APC’s strategy this year is to shift some funds from the intermediate-term bond positions (assuming no long-term bond exposure) to shorter-term treasury securities, CDs, and municipal bonds (for tax sensitive clients). The result: a shorter duration, principal protection and locking in a positive return. Then we will reassess in six months or so.
How can APC help?
APC would love to assist you in assessing your portfolio interest rate risk! We are happy to help and answer your questions. Feel free to call us at (888) 690-1231.
A well-informed client is a benefiting client. We hope this blog enlightens you.
Co-Author Steve Carlson