Managing Bond Risks When Interest Rates Rise
By Laurie Haelen
The start of 2022 found both stock and bond markets holding their value well after a strong 2021. As events of 2022 began to unfold, volatility began to emerge and threaten the continued upward march of the equity markets. Events like the Russia-Ukraine war, continued supply chain issues, and, of course, inflation, made interest rate increases inevitable for the foreseeable future.
The reality is we all knew the good times for stocks could not last forever. But many investors have been surprised by the severity of declines in the less risky portion of their portfolio: bonds. How could bonds be down double digits by the end of August when they are supposed to provide a haven for portfolios? More importantly, what can help mitigate the risk in bonds and help your portfolio maintain value in such challenging times?
After dropping the benchmark federal funds rate to a rock-bottom range of 0%–0.25% early in the pandemic, the Federal Open Market Committee began raising the rate toward more typical historical levels in response to high inflation. As inflation has remained stubbornly elevated, the Fed has accelerated these moves and has done, as of this writing, three .75% moves within the past few months. Additionally, the Fed has stated it will continue to be more aggressive as needed, even if it causes pain to investors and businesses alike, as the cost of borrowing rises while capital declines.
When interest rates rise, the value of existing bonds typically falls because investors would prefer to buy new bonds with higher yields. In a rising rate environment, investors may be hesitant to tie up funds for a long period, so bonds with longer maturity dates are generally more sensitive to rate changes than shorter-dated bonds.
Thus, one way to address interestrate sensitivity in your portfolio is to hold short- and medium-term bonds. However, keep in mind that although these bonds may be less sensitive to rate changes, they generally will offer a lower yield than longer-term bonds.
A more specific measure of interestrate sensitivity is called duration. A bond’s duration is derived from a complex calculation that includes the maturity date, the present value of principal and interest to be received in the future, and other factors. Your investment professional can provide you with information about the duration of your bond investments, as it is not an easy thing to calculate on your own.
When a bond is held to maturity, the bond owner receives the face value and interest unless the issuer defaults. However, bonds redeemed prior to maturity may be worth more or less than their original value. Thus, rising interest rates should not affect the return on a bond you hold to maturity but may affect the price of a bond you want to sell on the secondary market before it reaches maturity.
Owning a diversified mix of bond types and maturities can help reduce the level of risk in the fixedincome portion of your portfolio. One structured way to take this risk management approach is to construct a bond ladder, a portfolio of bonds with maturities that are spaced at regular intervals over a certain number of years. For example, a five-year ladder might have 20% of the bonds mature each year.
Bond ladders may vary in size and structure and could include different types of bonds depending on an investor’s time horizon, risk tolerance and goals. As bonds in the lowest rung of the ladder mature, the funds often are reinvested at the long end of the ladder. By doing so, investors may be able to increase their cash flow by capturing higher yields on new issues. A ladder also might be part of a withdrawal strategy in which the returned principal from maturing bonds provides retirement income.
Bond funds—mutual funds and ETFs composed mostly of bonds and other debt instruments—are subject to the same inflation, interest rate and credit risks associated with their underlying bonds. Thus, falling bond prices due to rising rates can adversely affect a bond fund’s value. Because longer-term bonds are generally more sensitive to rising rates, funds that hold short- or medium-term bonds may be more stable as rates increase. However, one benefit to a bond fund is professional management, which can be very helpful in navigating through the changing rate environments.
Whether you invest in individual bonds or a bond fund/ETF, there is a silver lining to this bond “repricing” due to interest rate changes. Whereas for many years, bonds yields lingered at 2-3%, now high-quality bonds are available with much higher coupon rates. Although not yet matching inflation, 4-5% bonds are now being issued, so the fixed income portion of your portfolio is going to give you a raise! As a matter of fact, even dividend-paying stocks are on sale now, and with the market’s decline you may be able to restructure your portfolio to provide a much higher income stream—and a chance at capital appreciation as well.
Another silver lining to be considered is the availability of tax losses in bonds or bond funds you already own. By selling the bond or fund in a taxable account, you can remain in cash for 31 days (money markets are now around 2%) and buy new bonds or funds with more attractive coupon rates. The loss can be used against any gains this year or carried forward to help mitigate taxes in subsequent years. An adviser can help you evaluate the benefits of this and ensure it is done correctly to avoid the wash sale rules, which can void a loss if one is not careful.
It is important to remember that all challenges present opportunities, and this includes market downturns. A proactive approach to achieving lasting financial success means evaluating your plan on at least an annual basis and ensuring that your investments match your needs. Over the long term, this will smooth out the inevitable volatility and hopefully enable you to enjoy the things that matter most to you.
Laurie Haelen, AIF (accredited investment fiduciary), is senior vice president, manager of investment and financial planning solutions, CNB Wealth Management, Canandaigua National Bank & Trust Company. She can be reached at 585-419-0670, ext. 41970 or by email at firstname.lastname@example.org.