Interest rates remain low thanks to Federal Reserve policies. And despite the improving economic outlook — with an unemployment rate around 6.2% and Q2 GDP growth that ran at a brisk 4% rate — interest rates look like they will remain low for some time.
Click to EnlargeIn fact, rates actually have dropped significantly this year from around 3% on the 10-year Treasury in January to around 2.5% currently.
There’s a lot of talk about interest-rate risk as the Federal Reserve looks to tighten monetary policy in the next year or so. The Fed has already drawn down some of its quantitative easing, and is set to end the program of bond buying in October.
Furthermore, many investors believe that Chairwoman Janet Yellen plans to raise interest rates within 12 to 18 months.
It has long been clear that the Federal Reserve cannot continue its path of easy money forever, and investors haven’t questioned whether tighter polities will hit … but when.
And as an investor planning for retirement, with a mix of income investments like bonds and stocks, this shift in the interest-rate environment is crucial to follow and understand.
If you’re in the dark about what to do with your portfolio, here are some tips on how to prepare:
Interest Rates Don’t Matter When Holding to Maturity
The biggest thing people hear regarding rising interest rates is that when the rate rises, the price of bonds goes down.
That’s true, because newer bonds that yield a better interest rate will be in more demand while older debt with a lower yield will be less valuable on the open market.
However, if you are an income-focused investor who holds bonds to maturity, that’s not a problem you need to worry about.
After all, if you never sell the bond, it doesn’t much matter what market pricing is; if you’re content with your coupon payments, then simply keep collecting them.
Be Wary of Long-Term Bond Funds
The fact that bond principal declines as rates rise is a big problem for bond funds, however, because the vast majority of bond funds do have turnover and sell bonds regularly. That leaves investors open to principal losses.
Consider that last year, from May to early July 2013 when rates on the 10-year T-note rose about 1%, the iShares 20+ Year Treasury Bond ETF (TLT) lost about 15%. That’s because roughly 90% of the holdings are more than 25 years in duration, and the longer the duration, the more susceptible bonds are to interest-rate increases.
This is a very real example of what you can expect in long-term bond funds when interest rates rise.
Short-Term Bond Funds Are Safe, But Don’t Yield Much
If you don’t like the idea of buying individual bonds but don’t want to get burned by raising rates, short-term bond funds are an alternative. There still is a risk of loss in principal, yes, but much less so.
As a working example, compare the deep declines in TLT to a less-than-1% decline in its sister fund, the iShares 1-3 Year Treasury Bond ETF (SHY), in that same May-to-July period that saw a significant uptick in interest rates.
Just remember that the yields in shorter-term bonds are much lower, but that’s the tradeoff you’ll have to consider if you want to avoid the risk of losing principal when rates rise.
Remember Bond-Like Stocks
If you’re looking for income, you might be frustrated by this struggle between settling for either risk to bond principal or settling for meager coupon payments. As such, bond-like investments including utility stocks, blue-chip telecoms, REITs or other stable dividend payers might be a decent supplement to your income portfolio.
There obviously is risk here, of course, and the loss to stocks could be much more significant than the loss to bond funds should things sour. And furthermore, since so many income-sensitive investors are shopping for dividends, many of these players have awfully high valuations.
Be Wary of Junk Bonds
One important thing to remember as an investor is that bonds are debt, and that higher interest rates mean higher costs for borrowing.
So as interest rates tick higher, it’s natural to see some bonds or bond funds yielding 6% or 7% or even more … but remember this big potential reward comes with big risk, since the kind of companies borrowing high-yield or “junk” debt have a better chance of default than most.
We have been starved for higher returns on government and corporate bonds for so long that I expect many income-oriented investors so hungrily load up on junk bonds should we see rising interest rates.
But if those funds suffer big bond defaults, those investors might regret chasing yield.
Jeff Reeves is the editor of InvestorPlace.com and the author of The Frugal Investor’s Guide to Finding Great Stocks. As of this writing, he did not hold a position in any of the aforementioned securities. Write him at email@example.com or follow him on Twitter via @JeffReevesIP.