The specter of rising interest rates brings a number of legitimate concerns about the wider effect on markets.
There’s worries about slower economic growth, rising expenses for goods and services purchased with credit, narrowing corporate profit margins as operating costs rise and, should the Federal Reserve’s tightening lead to a recession, an end to the current economic cycle.
While these are valid concerns, a rising-rate environment also signals positive changes in the economy.
For example, there is increased demand for capital to finance business expansion and greater demand from consumers for mortgages and other credit. Also, there will be a greater distance from the earlier credit crisis that necessitated rock-bottom rates.
In any type of interest-rate environment, many advisors recommend individual investors hold bonds.
However, many investors misunderstand why bonds should be an integral part of a portfolio. Equities typically deliver a higher return than fixed income. Bonds serve to dampen the volatility of stocks and allow retirees to withdraw from their fixed-income holdings during downturns in the stock market.
“Investors have been nervous about the thought of rising interest rates for many years,” says Mark Copeland, senior partner at Signature Estate & Investment Advisors in Irvine, California.
“Since bond prices fall as interest rates rise, most investors are concerned about their exposure to interest-rate risk in their bond holdings. In an effort to reduce risk, many investors wish to hold individual bonds over bond funds. We believe there is a misconception that holding individual bonds is less risky than owning bond funds in a period of rising interest rates,” Copeland says.
Every individual or bond fund is subject to potential hazards, including interest rates, credit and default risk. Individual bonds allow investors to reduce expenses and select bonds with different maturities and credit ratings. “The common thought is that owning individual bonds is really different than owning a bond fund because you can hold until maturity and get your principal back,” Copeland says. “This allows investors to receive money back at a specific date and does reduce interest-rate risk in a short-duration bond strategy.”
In an intermediate or long-term bond strategy, individual bonds may be subject to more interest rate risk due to illiquidity and trading costs. Longer-term bonds typically have higher returns than short-term bonds, but that comes with greater risk.
In a rising-rate environment, Copeland recommends that investors take steps to organize their fixed-income holdings.
“Look to higher-coupon corporate bonds with shorter durations as an alternative to long maturity government bonds. Consider increasing the allocation to high-yield corporate and municipal bonds as credit should improve with the economy, and an investor can capture increased yield. Floating rate bonds where the interest rate adjusts – often quarterly – provide more stability when interest rates are rising. Consider global bonds since most developed, and developing, countries are well behind us in the interest rate cycle and they are likely to continue lowering interest rates in the near future,” he says.
Many so-called “alternative” fixed-income strategies are designed to perform well during rate increases. Other strategies that rely on a broader fixed-income portfolio can better weather different interest-rate cycles, Copeland says.
Eric Nichols, president of Educated Wealth Strategies in Bethlehem, Pennsylvania, suggests sticking with shorter-maturity bonds in a rising-rate environment.
“While the interest rate may be less than those of longer maturities, these bonds are constantly turning over and maturing and being reinvested into bonds with higher interest rates. In bond funds, this makes the value less volatile in a rising-rate environment,” he says.
The same reinvestment strategy may be used with individual bonds in a time of rising rates. “Just remember that due to a possible lack of diversification, picking bonds of high credit quality is very important,” Nichols says.
Nichols says interest-rate risk is more pronounced in bond funds as opposed to individual bonds, because the buyer controls the interest rate and term to maturity of every single holding.
However, individual bond investing requires a great deal of due diligence, knowledge and proper timing. For many people, the research time to correctly pick individual securities is prohibitive. That’s in addition to other potential hurdles, such as trading costs and decisions driven by emotion and hunches.
“While you can control interest rate risk by holding individual bonds, it is important to remember that you may not have enough resources to build a well-diversified, fixed-income portfolio. Credit risk is important to manage as well,” Nichols says. “Bond funds will provide diversification that you may not be able to replicate through individual bond purchases. If you buy an individual bond issued by a company that defaults, I’ll bet you would have rather bought into a bond fund, regardless of the added interest rate risk.”