Although it may seem to go against common sense, bond investors do not like to see interest rates going up because of the inverse nature of bond prices and rates. Higher interest rates produce lower bond prices. The implementation of some bond portfolio strategies can minimize the effect of falling bond prices and help an investor pick up some of the higher yields that are on the way.
Basic Bond Concepts
Investors can save money and worry by keeping a couple of basic bond investment concepts in mind when planning and implementing a bond strategy. Remember that all bonds mature to face value. The rise and fall of bond prices is for bonds that have not matured. A bond investment can always be held to maturity to avoid a down market loss. Also, shorter maturity bonds have smaller price swings as interest rates change. If safety of principal is a primary concern, it is better to own short-term bonds than bonds with longer maturities.
Bond Portfolio Strategies
Bond investors typically use two strategies to protect values and interest earnings against interest rate changes. A laddered portfolio owns bonds spaced at different maturities, such as one, three, five and seven years until they mature. With this strategy, as the shorter bonds mature, the proceeds are reinvested at the longest maturity and highest yield. A barbell portfolio involves owning only short-term and long-term bonds, nothing in the middle. The long-term bonds will earn the higher interest and the short-term holdings earn higher yields as rates increase. A barbell portfolio works best if interest earnings are reinvested into the two ends of the barbell.
Diversify Your Portfolio
One strategy to protect against bond losses from rising rates is to diversify the types of bonds held in a portfolio. The most obvious counter to U.S. issued bonds would be bonds of foreign governments where rates are not expected to increase. Another option is non-investment grade, high-yield corporate bonds. With these bonds, the credit rating and business results of the issuer may have a greater impact on prices than interest rates. You want to find corporate bonds from companies that could receive a credit rating upgrade.
Do Not Stretch for More Yield
Low interest rates from bonds can push investors to consider longer term bonds to earn a little extra yield. If you expect rates to rise, this tactic will backfire as bond prices fall and your long-term bonds are locked in at lower rates. If you expect rates to start increasing, you want to shorten the maturity of your bond holdings, even if it means accepting lower returns. When rates do rise, you will be able to take your maturing short-term bonds and invest in higher rates, riding the interest rate increase rather than suffering from it.