The Federal Reserve is close to raising interest rates again—possibly even this year. That means your bonds will lose value, so what’s a balanced investment portfolio to do? Here are three things you can do to combat interest rates’ effect on your investments.


The Relationship Between Bonds and Interest Rates

As we’ve mentioned before, when interest rates rise, the value of bond funds falls.


When you invest in a bond, there are two monetary values you need to think about. First, a bond pays a fixed amount of interest every quarter, called the coupon rate. This value never changes until the bond is repaid (called maturing).

However, bonds are traded daily, just like stocks, so they also have a market value—how much money you’d get if you sold off the entire bond today.

Let’s say IBM issued a bond paying 5% and maturing in 2035. It cost you $1,000 to buy, so the bond pays you $50 a year ($12.50 a quarter). If interest rates go up to 10%, though, no one would want to buy your IBM bond for $1,000. It’s only returning 5%, while other new bonds are returning 10%.

So, in order to sell that bond, you have to sell it for less—enough that it’s $50 coupon rate (which, remember, never changes) equals 10%. So, people will pay $500 for that bond that originally cost your $1000 in order to get the 10% return.


So, while the interest stays the same, the market value of the bond changes with interest rates: when interest rates rise, bonds’ market values drop. When interest rates drop, bond values rise.

Given that the bond market is more than twice the size of the stock market, now you understand why professional investors are watching the Fed like a hawk.


The Fed didn’t raise interest rates at their March FOMC meeting, but they made it known that they are not ruling out some hike later this year. When that happens, you can expect the value of your bond funds to drop.

However, as rates rise, so does the return on any new investments in bonds or bond funds. So if you bought a new bond after interest rates rise, it’ll yield more than the bond you bought back when interest rates were low.


Therefore, when you look at your bond investments, it’s important to make a distinction between prior investments and what you will be investing going forward.

Option One: Stay The Course

Some experts say you should simply keep your funds and rake in the income from them. Of course, this means the value of your existing bond funds is likely to go down when interest rates rise. But even though the price of bond funds may change, those monthly interest payments will stay the same.


And, if you invest in bond funds on a monthly basis—called dollar cost averaging—your return on every purchase will increase as interest rates go up.


However, if you’re within ten years of retirement, and you intend to switch your bond funds into other investment vehicles in that time horizon, this option probably isn’t your best bet, because you’ll lose money when you sell those funds.

Option Two: Try Bond Funds with Different Terms

Others say you might need to rethink the term of the fund. A bond is a debt instrument, which means it has to be repaid at a specified date (called the maturity date). Some bonds have a five year term, others run as long as 50 years. For example, a 20-year bond issued in 2000 would only five years left to maturity in 2015. Just like all bonds are not the same, not all bond funds are the same. Some funds specialize in shorter term bonds (both bonds with short terms and bonds close to maturity) while others specialize in bonds with longer terms.


Bonds with a longer maturity generally have a higher return than those with a shorter maturity, but they also carry a higher risk of loss. It’s the classic risk/return trade-off.

When interest rates rise, therefore, it’s not surprising that the value of bonds and funds with longer maturities are affected more. Vanguard offers a nifty slider tool to visualize this.


The more you shift toward shorter term bond funds, the less you will be affected by rising interest rates (but the lower your overall return will be).

Option Three: Rebalance Your Portfolio In Preparation

If you’re like many people who invest monthly, you may consider a different tactic: rebalance your portfolio to take advantage of lower bond prices. When interest rates go up, you will notice the value of your bond funds go down. If the rate hike is minimal, your impact will be, too, but if interest rates go up significantly, your portfolio could get hit quite a bit. Rebalancing before the interest rate goes up helps you get around that.


Let’s say that, in the long run, you want to keep about 20% of your total investment portfolio in bond funds. You obviously want to minimize the hit that 20% will take with rising interest rates. So here’s what you do:

Lighten up on your existing bond funds before interest rates rise to something less than your ideal ratio. Let’s say 10%. Doing this lets you sell those bond funds at their higher values before they begin falling. You still want about 20% of your portfolio to be in bonds, so after interest rates rise, step up your monthly buying. The prices for those bond funds will be dropping, so instead of allocating the usual 20% of your monthly purchases to bonds, allocate 30% or more of your monthly purchases toward the bonds.


After some time, your portfolio will end up again with 20% in bond funds. But you would have paid less, because you sold when values were higher and rebought when values were lower. In total dollars it’s not likely to be a game changer, but if you’re willing to put in a little effort, you will be rewarded with a somewhat higher return.

There is no “one strategy fits all.” Your best bet is to be aware of what’s happening with interest rates, and watch what effect it has on bond fund values.

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