I recently issued a message to Conservatory Members about equity markets in a gradually rising interest rate environment. Today I will address bonds, which are commonly considered poor investments when rates are on the rise.
The math behind bonds and their market value is relatively simple: if you own a $1000 face value bond with a 5% coupon and interest rates have risen to 6%, no one is going to pay you $1000 for your bond. They will discount the price until the yield-to-maturity at least equals 6%. That is because as new bonds are issued, they must come out at the prevailing rate of 6%. So, we don’t want to own bonds that are going to decline in value. Right?
Wrong. We probably don’t want to hold a lot of long-term bonds of high quality (perhaps nothing longer than five years or so until maturity). That’s because we may want to liquidate those bonds before maturity, in which case we would suffer a loss. But, what about shorter-term bonds (say under five years until maturity). We are likely to hold them until maturity and get our face value back – earning interest along the way.
And, as our shorter-term bonds mature, we will reinvest them at the higher prevailing rates.
Studies have shown that owning a portfolio of staggered maturities is beneficial even as interest rates rise. This is most efficiently and cost-effectively accomplished through mutual funds. The market value of the funds will decline in the short term as rates rise, but every day or so one of the hundreds or thousands of issues held in the fund will mature and that money will be reinvested at a higher rate.
To ensure you are truly getting a staggered (or often referred to as ‘laddered’) portfolio of bonds, hold three or four different funds: A one-year fund; two-year fund; three-year fund; and perhaps a five-year fund. Avoid ‘Intermediate-term’ or ‘Total Bond Market’ funds that may hold long bonds to boost rates at the expense of increased risk.
And, by all means, house these bond funds in a well-diversified portfolio of mixed asset classes to manage overall portfolio risk. That will enable you to enjoy the increasing income from rising interest rates while still getting a full night's sleep.