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Philip van Doorn

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May 5, 2022, 9:31 a.m. EDT

Here’s how you can play it safe with your investments as interest rates rise

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By Philip van Doorn

When interest rates rise, as is happening now at an accelerated pace, bond prices fall. But that doesn’t mean you should avoid bonds.

You may have read that bonds have performed poorly as the Federal Reserve has begun to tighten monetary policy. That’s only half the story. Credit quality in the U.S. is strong — defaults are rare. Nearly all bond issuers are making interest payments on time.

On May 4, the Federal Open Market Committee raised the federal funds rate by half a percentage point to a range of 0.75% to 1%. The Federal Reserve also will begin to reduce its bond portfolio in June, which can accelerate the increase in long-term interest rates and the decline in bonds’ market values.

Holding a portion of your portfolio in bonds is actually a way to cut risk. That may sound counterintuitive but read on. Explained below are strategies that can help you mitigate the risk of bond investments, even though the current interest-rate cycle will likely push prices down.

The mechanics of bonds

Bonds’ market values have declined. What does that mean to you? If you hold a bond and plan to keep holding it until it matures, the decline in market value doesn’t change the fact that you will receive the face value when it matures.

If you purchased a bond at a discount (for less than the face value), you will have a gain when it matures. The opposite is true if you paid a premium for your bond. The day-to-day price fluctuation doesn’t affect the payout at maturity. You continue to receive interest until the bond matures.

But if you own shares of a bond fund, your share price has been declining. But the interest is still flowing, and as bonds mature in the fund, they will be redeemed at face value and replaced with higher-paying (or higher-yielding) bonds. That eventually helps the share price to recover. How much does the decline in your bond fund’s share price bother you?

With inflation running at a 40-year high , it may take a long time before the upward direction of interest rates (and consequent decline in bonds’ market values) reverses. Can you wait? How long might you have to wait?

If you have money to invest, bond-fund or individual bond investments have already become more attractive with higher yields.

A case for bonds

A traditional model for stock- and bond-market exposure is called 60/40, with 40% of a portfolio invested in the bond market either though individual holdings or shares of bond funds.

The notion of a 60/40 portfolio seemed antiquated during the long period of declining interest rates, when stocks have produced some of the best performance in decades.

Central banks’ stimulus, low interest rates and very low (or even negative) yields for long-term bonds have pushed money into U.S. equities. The S&P 500 Index’s /zigman2/quotes/210599714/realtime SPX -1.51% average annual return (with dividends reinvested) for the past five years is 15.8%. That compares to an average of only 7.3% for the previous 10-year period, according to FactSet.

Meanwhile, profits for U.S. companies hit their post-war maximum during 2021:

High inflation and rising costs, especially for labor, and an eventual resistance to price increases may push the the above chart in the other direction. Meanwhile, the Federal Reserve is pointing to an accelerating cycle of increases for short-term interest rates an d a reduction of its bond holdings , which has the bond market already sending long-term rates significantly higher this year.

Taken together, that makes this an ideal time to consider adding more bond-market exposure , according to Mark Hulbert.

Find out your bond fund’s duration

A bond portfolio’s average duration is a measure of its sensitivity to the movement of interest rates. It factors in premiums or discounts when bonds are purchased and is expressed as a number of years. The higher the duration, the more volatile the bond fund will be as interest rates move up or down, and the longer it will take for a downward price cycle to reverse as bonds mature at face value and are replaced by higher-yielding bonds.

Hulbert explains how duration affects volatility and provides simple advice on how to reduce bond-fund risk in this aptly named article, as part of the How to Invest series :

You can beat your fear of losing money with bonds as interest rates rise — if you understand this one thing .

A bond fund’s name will give you some idea of its duration — the fund may have “intermediate” or “short-term” in its name. But you should find out your fund’s exact duration, which is easy to do on the fund manager’s website. The average duration for the Vanguard Intermediate Term Treasury ETF /zigman2/quotes/200157958/composite VGIT -0.22% , for example, is 5.3 years.

/zigman2/quotes/210599714/realtime
US : S&P US
3,585.62
-54.85 -1.51%
Volume: 2.22B
Sept. 30, 2022 5:55p
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/zigman2/quotes/200157958/composite
US : U.S.: Nasdaq
$ 58.31
-0.13 -0.22%
Volume: 3.25M
Sept. 30, 2022 4:15p
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