With the federal reserve board executing on their promise to raise interest rates, the old axiom “when rates rise, bond prices fall” puts investors in a precarious situation. The question, “Should I retain bonds in the portfolio or sell them because they’ll lose value?” has merit and highlights a reasonable concern that follows the right train of thought. However, while the world of investing fits many descriptions, it most certainly is never characterized as black or white.
First, a quick reminder on what a bond is and how it works. A bond is essentially an investment whereby you loan money for a specified period of time and earn interest for making that loan. Money is typically loaned to a government (i.e., the United States), a municipality (like the County of Los Angeles), or to a corporation (ranging from Amazon to Viacom). And, you, the investor, are paid interest each year for the loan you made. At maturity of the loan, you’re then repaid the Face Value of the bond.
For a quick illustration, let’s say you buy a Face Value $100,000 bond issued by Amazon, with a 3% coupon (interest payment) that matures in 10 years. Amazon pays you $3,000 every year for the next 10 years, and in the 10th year they repay you the $100,000 you loaned them. But, what if interest rates go up to 4%? Now, if Amazon wants to borrow money, they pay new bond buyers 4% (or $4,000 yearly) on a $100,000 loan.
You can see that if rates go up, and you own the 3%-paying bond and you want to sell the bond, investors will pay you less to buy that position because they can get a bond that pays 4%— why would they want yours only paying 3%?
The challenge is that when you only consider the example above, you’ll likely be running from bonds in a rising rate environment. But, if you take other investment elements into consideration, you may evaluate your situation and find bonds can still be a complement to a successful investing strategy. Bonds provide diversification from stocks and real estate—think of “not keeping all your eggs in one basket” if you were to trip and fall. Meaning, if the stock market or real estate market were to decline in value, then you would have greater total portfolio safety by being diversified and owning different types of assets. Please note that diversification does not guarantee against a loss. Also, for retirees and other long-term investors, you may have bond positions that pay higher rates of interest from earlier years that still meet your requirements. If you were to sell, you’d be stuck in a situation wondering, “What do I buy to replace the income I was generating”? One more compelling idea is that, for the investor who is reinvesting income earned from the bonds, buying more bonds as interest rates rise will help their total bond income increase on the reinvestments.
To idly conclude that you want to fully exit bonds as interest rates rise requires further examination. Sure, owning long-term bonds in this environment can introduce more risk of current principal value, but shorter term bonds have less volatility (or change) as rates rise and can still add safety and a buffer from many other investment risks. Like another old adage, “It’s not simply black or white, but really shades of grey”.
This article was previously published by Runyan Capital Advisors, and the original piece can be accessed by clicking here.
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