Are you afraid of the effect of rising interest rates on your bonds? Most of the new investors find the relation between bond prices and interest rates quite illogical. When you purchase bonds, you invest in a stream of cash payments for the upcoming years. You receive these cash payments as periodic interest payouts and the principal after the maturity of bonds.
Interest rates tend to increase long with the expansion of the country’s economy. When the economy expands, it is excellent news for the country, but bad news for the investors. Increase in interest rate does not necessarily affect all the investments such as stocks. Stocks receive appreciation in such environment, especially in the 12 months after the increase in rates. However, bonds lose their value because of the competition against new issues with comparatively better yields.
3 Tips to Balance Bond Portfolio in a Rising Rate Economy
- Concentrate on Total Returns: According to financial experts, an increase in interest rates is coupled with decrease in price of the bonds and principle value, but the long-term investors should not be affected by these behaviors. There are chances that the rising rates will boost the value of bonds in the longer run. The key is to focus on total returns instead of the current market value of the bond because rising rates will build better yields in future. You should reinvest your income and buy higher-yielding bonds for your portfolio.
- Diversification is crucial for your portfolio: Some thoughtful steps can help investors to build a protective shield for their investments. Diversification is the most important part of creating a successful bond portfolio.According to Investopedia.com:“A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.
Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.”
A balanced portfolio should consist of other assets including equity investments and stocks along with bond investments. You can consult your financial advisor and create a diversified portfolio. You should diversify your bond assets. For example, you can add an international component to your fixed income portfolio for stability. Moreover, it is best to hold on to your bonds for a longer period.
- Transfer your investments into short-term bonds: If you are focusing shorter-term bonds and the rise in interest rates is diminishing your bond principle value, it might be helpful to shift to short-term bonds. It will help you in balancing duration and lower down any losses to your portfolio.