06 Nov Bonds And Rising Rates
There’s been a lot of froth over the last few months about moving back in to shares – as usual it’s after the market has climbed roughly 20%!
The suggestion is investors will now be moving their money back towards risk assets from defensives like cash and bonds/fixed interest.
On the latter, bonds have done particularly well over the last few years, providing good returns and balancing volatility in portfolios that have considerable weight in equities.
However, given the impact rising rates have on bonds, it’s likely future returns won’t be as spectacular.
We’re constantly being reminded rates can’t stay low forever, leading to some bubble calls on bonds and that investors should be running for the hills, which isn’t the case.
As interest rates rise, bond prices fall because coupons paid (distributions) on existing bonds are less than market returns, this is due to the fact new bonds are issued with a higher interest rate.
As a basic example, if your bond is paying 5% and interest rates climb 1%, newly issued bonds might now be paying 6%, so as a result the bond paying 5% would be worth less if it was sold before maturity.
There is the possibility of a negative return if there is a sharp rise in interest rates, meaning that the value of the bond fell to a level that the distribution didn’t cover the fall in the bond price.
Of course any capital loss only occurs if the bond is sold before maturity.
Most investors would be holding a bond fund though, and within the fund there would be a range of bonds with different maturity dates and return rates.
Holding a fund, as opposed to a single bond, smooths the volatility for the investor, like any form of diversification.
For the long term investor, who is re-investing distributions, this is an advantage because their reinvestment buys higher yielding bonds.
As within your portfolio, diversification is the key within your bond holdings.