As the Federal Reserve remains in a holding pattern of keeping interest rates near historical lows, investors know it’s only a matter of time before they start rising. Although that isn’t expected to happen any earlier than 2015, fund managers and ordinary investors are thinking about the downward pressure it could put on outstanding bond prices. Analysts and advisers say there’s less interest rate risk in short term bonds, but how you should handle the coming years all depends on your risk tolerance and reason for holding bonds.
Bonds and interest rates usually have an inverse relationship. Typically, when interest rates go down, bond prices go up and when interest rates go up, bond prices go down. Investors know that it isn’t a matter of if interest rates will rise but when. The latest from the Fed is that it will keep interest rates at or near zero until the unemployment rate reaches 6.5%. As of April it was still 7.6%, and experts say it could be at least a couple of years until it reaches the targeted rate.
Others say it could be much longer. PIMCO Managing Director Bill Gross said in a December 2012 newsletter that the unemployment rate could be stuck above 7% for the next 10 years. It puts some investors in a precarious position because they know there’s considerable interest rate risk ahead. And with CD and money market accounts paying less than 1.5%, there aren’t many viable alternatives for yield in the meantime.
“We need to be prepared to see the value of bonds decrease quickly as interest rates go up,” says Kimberly Foss, CFP, CPWA, founder and president of Empyrion Wealth Management in Roseville, Calif. “It is coming; it’s just a matter of when.”
Bob Philips, managing principal at Spectrum Management Group in Indianapolis, anticipates interest rates will remain near their current levels for at least the next couple of years. He says that although bond yields have come down over the past few years, bondholders have been recently blessed with decent yields and capital appreciation. Philips says that capital appreciation has now leveled off, but bondholders are still earning some yield.
As we move closer to the point where interest rates start to rise, Philips says, investors should primarily focus on protecting principal.
“I don’t think investors will have to think about that this year but when they do, I’d move into shorter-term funds,” Philips says. “You’ll be paid less, but it’s a defensive position to try to avoid loss of principal.”
There’s an added risk in funds: Considering the low-yield environment, it’s possible that some managers have strayed into higher risk bonds to make their incomes more competitive.
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