Interest rates rise when the economy expands - and that means good news and bad news for investors. Stocks, which benefit from increased consumer and capital spending, are positively affected in a rising rate environment, particularly in the 12 months following a rate increase. However, bonds tend to be negatively impacted when rates rise. Higher rates drive bond prices down because new issues make older bonds with lower yields less attractive.
Focus on total return
Despite the fact that bond prices decline and principal value diminishes when rates rise, long-term bond investors may not need to take any action at all - because rising rates can positively affect bond performance over the long run. Investors should stay focused on total return as opposed to market value. While rate increases erode the value of the securities, the total return over time is boosted by those same rising rates. When investors reinvest the income they receive from their bonds, they are buying higher-yielding bonds.
Shift into shorter-term bonds
If, however, investors feel rate increases will be detrimental to their portfolios, especially those with shorter-term needs, shifting into shorter duration bonds can help in a rising rate cycle. Duration, a measure of interest rate sensitivity, is the percentage change in the price of a bond given a 100 basis point change in yield. The lower the duration, the lower the sensitivity to swings in interest rates, which help protect the principal value of the bonds.
There are measures bond investors should take regardless of the rate environment to protect their portfolios - namely, diversification. A properly balanced portfolio, for almost any investor, should include other asset classes in addition to bonds, such as equity investments.
Investors must also diversify within their bond allocation. Adding an international component can help stabilize a fixed income portfolio because most international markets often move in different economic cycles than the U.S. Investing in securities that protect against inflation, such as Treasury Inflation Protected Securities (TIPS), are another good tool since the principal value of TIPS resets as the Consumer Price Index rises, providing for a larger coupon payment as interest rates increase.
The best way to weather rising rates is to hold onto bonds for the long haul and focus on total return, which actually benefits from rising rates over time. Shorter duration bonds can also help in this environment, as well as diversifying among different types of bonds. Of course, maintaining a portfolio that is properly balanced among asset classes is always the best protection of all.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.