Yahoo Finance Before Interest Rates Rise, Revisit Your Bond Holdings
When it comes to headlines, it's bonds, bonds and more bonds. You may be wondering, "Why have I been hearing so much about bonds lately?" Chances are the chitchat was closely linked to rumors the Federal Reserve would remove the "considerable time" guidance from their timetable for raising the federal funds rate. Note: They didn't. The Fed stated Wednesday that it will remain patient when it comes to raising rates, and it is still widely anticipated it will be at least mid-2015 before they take action.
That being said, higher interest rates, whenever they come to fruition, could impact the performance of your investments, and your bonds in particular, in a number of ways.
Here's why: Over the last 30 years or so, we have seen interest rates go nowhere but down. When that happens, the price of bonds goes up. But when rates rise, the value of existing bonds decreases, which means a bond investor can suffer a large loss. For that reason, investors are going to have to be very strategic regarding the types of bonds they buy in a rising-rate environment. It is an environment most investors do not have the expertise or resources to successfully navigate.
The good news? You can make it easier on yourself by investing in bond mutual funds rather than individual bonds for reasons such as these:
Increased liquidity. If you buy a bond fund today and you want to sell it tomorrow, you can. You may not be able to do that with an individual bond, simply because it would be more difficult to find a buyer in the secondary market. With a bond fund, it is much easier to get your money when you need it.
More buying power. Individual bonds are generally subject to minimum investment requirements and are sold in increments. In contrast, investors can buy any amount they want with a bond fund. This is important for two reasons:
-- Many individual bonds are sold for at least $1,000, in increments of $1,000 (or even $5,000). If you only have a small number of dollars to invest, you may have to hold off on putting your money to work until you meet the minimum investment required. However, with a bond fund, you can invest your money right away.
-- Being able to pick the exact amount of bond funds you want to buy is especially important when implementing your target asset allocation. An asset allocation dictates how money should be split between different asset classes. With individual bonds, you can't be as precise, and could likely end up with a less optimal portfolio.
Diversification and reduced risk. Bond funds provide better diversification compared to individual bonds. Suppose you have $1,000 you want to invest in bonds. If you buy individual bonds, you might only be able to buy bonds with one issuer, due to minimum purchase requirements. If that bond issuer defaults, it can have a very significant impact on the value of your accounts. However, with a bond fund, you might get 100 different issuers within a single fund. With your money spread over different issuers, having one default represents a much smaller impact on your investments.
Less reinvestment risk. Individual bonds come with reinvestment risk. In other words, investors may not be able to reinvest the cash flows generated from these bonds. Most bonds pay interest periodically, but these interest payments may be too small to reinvest. With a bond fund, though, interest payments can be automatically reinvested, and that compound effect can help build wealth over time.
Easier monitoring. It is much easier for investors to evaluate and monitor bond funds than individual bonds. Investors can go to websites such as Morningstar to obtain star ratings for a bond fund, and compare its performance to its peers. Although there are some resources available for evaluating individual bonds, they can be more difficult for everyday investors to use.
Evaluating bond funds for your investment strategy can be complex, especially in light of the amount of recent chatter on the subject. Once you've identified bond funds in which to invest, how much you should invest depends on your risk profile. For example, a more conservative investor would likely be more heavily invested in bonds than a more aggressive investor, who is more comfortable with risk.
If you need help determining how much you should be invested in bonds -- now as well as later when interest rates rise -- try an online asset allocation calculator or contact an investment advisor.
Michael Rittershaus is the president of Smart401k, offering easy-to-use, cost-effective 401(k) advice and solutions for the everyday investor. Smart401k's advice has been featured on various news outlets, including FOX Business, USA Today and The Wall Street Journal.
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