A key tenant in properly managing your investments is to maintain a well diversified portfolio. A well diversified portfolio usually contains a mix of stock or stock mutual funds and fixed income investments. Stock mutual funds are long term investments that can provide you with growth over a long period of time. Fixed income investments can provide you with short term liquidity, income, and a buffer against stock market volatility. Bond funds have long been a staple in most fixed income portfolios. However, with the threat of rising interest rates, many bond funds may no longer provide the stability you are seeking in the fixed income sleeve of your portfolio.
Interest rates, after dropping close to all time lows, have begun to increase. The bond market had experienced what is commonly referred to as a 30 year bull market. Until recently, interest rates had been steadily dropping since the 1981. As interest rates fell, bond owners experienced a corresponding increase in the value of their bonds. Generally, when you buy a bond and interest rates decrease, the market value of the bond will rise. On the other hand, if interest rates increase, the market value of the bond will drop. If you hold an individual bond to maturity, assuming the issuer does not default, your entire principal will be returned, regardless of the prevailing interest rate.
Many investors prefer bond mutual funds over individual bonds because they provide greater diversification, liquidity and professional management. However, recently bond funds have experienced decreasing yields. As bonds within mutual funds mature, they are replaced with lower earning bonds. In an environment of increasing interest rates, another major concern is the potential loss of principal. If many investors decide to sell their bond funds, the fund managers may be forced to sell individual bonds at an inopportune time. The manager may be forced to sell bonds before maturity, at less than the face value.
The duration of a bond fund is a measure of it’s sensitivity to changes in interest rates or interest rate risk. For example, if the duration of a bond fund is 5 years, and interest rates decrease by 1%, the value of the bond fund should rise by about 5%. If interest rates increases by 1%, the value of the bond fund should drop by 5%. Short term bonds have a lower duration and long term bonds have a higher duration. You can find the duration of most bond funds at Morningstar.com.
With the threat of higher U.S. interest rates, consider moving your longer term bond funds into short term bond funds or international bond funds. For greater security of principal, move your bond funds into an FDIC insured CD ladder or equity indexed CD. Bond funds usually represent the safe portion of your portfolio, and some of your principal may be at risk as interest rates rise.