Provided by RBC Wealth Management and John Barnes
Following the financial crisis of 2008, many investors rushed to the investment “sidelines” in order to avoid risk of any kind. While understandable given the market environment those that chose to remain invested in the markets have been well rewarded as both bonds and stocks have posted strong performance numbers since then. Bonds, given their perceived level of safety and backstopped by the Federal Reserve’s long-term commitment to low rates, benefitted the most with investors pouring billions into bonds and bond-based mutual funds.
Unfortunately however, investors may have “over-concentrated” their portfolios with bonds and bond funds. Additionally “the search for yield” within the bond asset class led many to take on too much credit risk or lengthen maturities exposing them to interest rate (or duration) risk. As a result, they may not be in quite the safe position they had envisioned. The reason? Bonds, like all investments, do carry some risk — in particular, interest-rate risk. And with the recent talk of the Federal Reserve considering lessening their monetary policy stimulus, the time may be near when that risk becomes apparent.
As you may already know, especially if you own bonds, interest rates and bond prices typically move in opposite directions. Consequently, if interest rates were to rise, the value of your bonds would fall, because no one would be willing to pay you the full face amount of your bonds when newer ones are being issued at higher rates.
You have likely seen the value of your bond portfolio change recently as market conditions have become more volatile due to the growing debate over the Fed’s next course of action. The Federal Reserve is actively working to keep short-term rates low, probably until 2015, at least. But the Fed has much less control over long-term rates — and these rates have far more room to move up than down. With the U.S. economy showing signs of recovery and the Fed beginning to discuss a “tapering” or reduction in their monthly stimulus efforts expectations are high that rates could begin to rise in coming months.
While we don’t feel rates are poised to move sharply higher imminently, we do believe investors need to take a proactive stance with regard to their bond portfolios. So, what should you do?
Here are a few suggestions:
• Review your portfolio. If you have taken on to much credit risk or interest rate risk, you may want to consider making some adjustments as these bonds are likely to be much more subject to volatile price swings from changes in interest rates. You could decide to sell some of these long-term or lower-rated bonds and put the proceeds into investments that will help diversify your portfolio — because diversification is still essential to a successful investment strategy. Make sure to include the composition of your bond funds in the review.
Keep in mind, though, that everyone’s situation is different. Your investment mix should be based on a variety of factors — your age, risk tolerance, long-term goals, and so on. If you are considering selling some of your long-term bonds, you may want to consult with a financial professional for guidance on how to properly diversify your holdings.
• Build a bond ladder, or restructure an existing ladder. A bond ladder may prove beneficial to you in all interest-rate environments. To construct this ladder, you need to own bonds and other fixed-rate vehicles, such as Treasury securities and certificates of deposit (CDs) of varying maturities. Thus, when market interest rates are low, you’ll still have your longer-term bonds, which typically pay higher rates than short-term bonds, working for you. And when interest rates rise, as may be the case soon, you can reinvest your maturing, short-term bonds and CDs at the higher rates.
It can be unsettling to look at your investment statement and discover that the value of your bonds has fallen. But, as we’ve seen, you do have methods of coping with rising rates and falling bond prices — we encourage you to be proactive, consider your options carefully and make those moves that can help you continue making progress toward your financial goals.
This article is provided by John Barnes, a Financial Advisor at RBC Wealth Management. The information included in this article is not intended to be used as the primary basis for making investment decisions. RBC Wealth Management does not endorse this organization or publication. Consult your investment professional for additional information and guidance.
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