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Are Higher Interest Rates Bad News for Bonds?

Mark Smith, CFP®, CPA/PFS, CIMA® - Thursday, April 13, 2017

Interest Rates and Bonds | M.J. Smith & AssociatesIn the investment world, one theory holds that if interest rates rise, bond prices will likely move lower. So, when the Federal Reserve raised short-term interest rates last month and signaled two further rate increases in 2017, the news caused some bond investors to raise a red flag. Since our firm’s philosophy has always been to maintain broad diversification across bond and stock categories, our clients may also have had some concerns.

First, let’s clarify that if you own individual bonds (as opposed to shares in bond funds), nothing should change for you. Regardless of any price changes, the individual bonds you own should continue to mature at par value, and you should receive the stated coupon rate. If you own shares in a mutual fund that holds bonds, however, you may be affected to some extent by rising interest rates.

 

What the Effect Can Depend On

A recent article by Morningstar’s Eric Jacobson showed that the effect of interest rate increases can depend on whether investors believe the Fed is acting too quickly, too slowly, or not enough. Jacobson compared two periods – one in the mid-1990s and one in the 2000s. He found that when the Fed increased rates rapidly in 1994, investors pushed longer-term yields higher in step with the Fed’s short-term rate hikes, causing long-maturity bonds to suffer. However, from 2004 to 2006, the Fed took a more measured approach, raising short-term rates by four percentage points. During that time, Treasuries maintained a flatter yield curve, and didn’t rise nearly as much as the Fed’s rates did. According to Jacobson, while prices fell for both the 10 and 30-year bonds, the 10-year bond (factoring in interest) only lost 1.7 percent for the period, while the 30-year bond increased 2.2 percent. He added that the Lehman Brothers Aggregate Bond Index also rose 3.4 percent during that time.

Jonathan Golub, chief U.S. strategist at RBC Capital Markets, told Business Insider that the yield curve for bonds still seems normal, and while it’s too soon to predict the impact of future interest-rate hikes on stocks, he believes, “the Fed would have to do a lot of work in order to damage this economy.”

 

Five Key Points

In the days following last month’s Fed rate-hike, several bond-fund managers also sought to reassure investors that rising rates don’t always mean bad news for bonds. In interviews with the Associated Press, Ford O’Neil of the Fidelity Total Bond fund, and Mary Ellen Stanek and Warren Pierson of the Baird Core Plus Bond fund, offered five key points that investors should keep in mind: 

  1. Bonds will stay in demand. As Baby Boomers retire, they’ll want investments that can provide income, and that should set the baseline demand for bonds, no matter how often the Fed raises rates.
  2. Rising rates have an upside. That’s because as interest rates increase, prices for older bonds decline, but new bonds pay more in interest. So, if interest rates rise gradually, the higher income from new bonds can offset the falling prices of older bonds.
  3. Who knows what the government will do next? Rate increases by the Fed are just one of many potential changes coming from Washington that could affect the bond market.
  4. Control what you can. According to these bond-fund managers, investors should invest in funds with low expense ratios, and also stay diversified to help hedge against uncertainty.
  5. Look for higher volatility and lower returns. With interest rates rising, bond prices could likely decrease. Inflation is also a risk that could further affect bonds.

When working with our clients on their bond positions, our firm has tended to tilt portfolios toward higher-quality positions with shorter maturities. This serves to help dampen the inherent risks associated with rising inflation and interest rates.

If you are wondering what to do with your bond portfolio as Fed interest rates rise, we can help. Our experienced team of advisors works with clients to help them understand their appetite for risk, develop strategies to stay diversified, and focus on keeping fee expenses low as bond funds decline. Contact us for a complimentary, no-obligation consultation or a second opinion on your portfolio. More rate hikes may be on their way soon. Are you ready?

 

 

 

The information contained in this blog does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of Mark Smith and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Investments mentioned may not be suitable for all investors. Past performance is not a guarantee of future results. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions. Diversification does not ensure a profit or guarantee against a loss. Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. There is an inverse relationship between interest rate movements and fixed income prices. The Barclays Capital Aggregate Bond Index, which used to be called the "Lehman Aggregate Bond Index," is a broad base index, maintained by Barclays Capital, which took over the index business of the now defunct Lehman Brothers, and is often used to represent investment grade bonds being traded in United States. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will. Links are being provided for information purposes only. Raymond James is not affiliated with and does not endorse, authorize or sponsor any of the listed websites or their respective sponsors. Raymond James is not responsible for the content of any website or the collection or use of information regarding any website's users and/or members.

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