The distrust of the stock market this past year has encouraged investment flow into the bond market. The bond market typically provides a more conservative investment than equities as well as a regular fixed income payment to the lender. When you (the lender) purchase a bond, you are loaning money to the government or a corporation over a specific period of time while collecting steady income from the bond issuer. The bond is then paid back to you at the end of period, known as maturity date. Sounds simple, right? Well, the bond market is supposed to be a “risk-free” asset class but there are some risks associated with owning bonds. Prices of bonds fluctuate during times of interest rate changes. In a declining interest rate environment the prices of bonds tend to increase. This is because most likely the economic conditions are of concern and investors are moving towards a more conservative asset class. Due to several factors we are currently in a low interest rate environment so the bonds held in your portfolio should have increased in market value and be worth more today than few years ago. Just the opposite happens to bonds when interest rates rise. The market value of your bonds will decline when interest rates increase because you are most likely holding a bond that is paying less interest than current market conditions offering and your bond is not as attractive and worth less. Your regular fixed income payments will not change if your bond is worth less because you purchased a fixed rate regardless of the price.
This is important to understand as you purchase bonds for your investments because they are not only sensitive to interest rates but inflation as well. A high inflationary environment will erode the value of your bonds because of the difference between your income and inflation. If you are earning less income from your bonds than current inflation percentage, you are losing money.
The best way to protect investments from interest rate risk is to have a laddered approach for your bond portfolio. A laddered approach has bonds maturing every year over a ten year period. This allows you the opportunity to take advantage of current economic conditions that will impact bond prices, such as interest rate fluctuations or inflation. In a low interest rate environment it is best to have more bonds maturing in the shorter end, say 1-5 years, so that when interest rates increase the bonds will not have a long maturity of low interest paying bonds. I would much rather have a bond paying me 4% fixed income every year for five years than paying me 2% fixed income. If this means you give up the 10 year ladder and only have a six year ladder that is fine because your investments will be rewarded in the years to come when they mature and you can buy a higher interest rate bond in its place.
Investing in bond mutual funds does not allow you the advantage of laddering but knowing what the duration is will assist you in the types of mutual funds to purchase. Short term funds (1-3 years) versus intermediate term funds (2-7 years) are common.
Good luck and know what you are invested in.