My birthday is coming up. I mention it not in the hopes that you’ll shower me with gifts (I wear a medium), but because every year around my birthday, I take a hard look at my portfolio and see what adjustments need to be made.
Usually, all I do is make a few small adjustments to make sure I’m not grossly overweight in any one asset class. I don’t sell my stocks because I expect a correction or other calamity. I’m in for the long term.
Last year, I drastically reduced my bond fund holdings in anticipation of higher interest rates. Bond funds typically lose money when rates rise.
To understand why this happens, you need to know that the underlying bonds typically drop in price too.
If a corporate bond yields 4% and a risk-free 10-year Treasury yields 2.8%, that 4% corporate bond is priced according to a number of factors. An important one among them is what investors can earn without taking any risk by owning a Treasury. In this case, investors are getting an extra 1.2% for taking on the risk.
If the yield on the Treasury goes up to 3.1%, the same corporate bond should drop in price (pushing the yield higher) to compensate investors for the risk of owning the bond. Think of it this way: Why would an investor pay the same price for an investment when they can earn 3.1% risk-free instead of 2.8%? The yield on the investment must be higher now that the yield on risk-free investments is higher.
What About Individual Bonds?
There’s an important difference between owning bonds and owning bond funds. I do own bonds and will continue to hold them.
A bond has a maturity date. On that maturity date, you will be paid the par value of the bond. Unless the company goes bankrupt, you will get the par value – usually $1,000. So if you paid $1,000 or less for the bond, you’ll get all of your money back and maybe more.
Though a bond fund is made up of bonds, the fund itself has no maturity. Therefore, there is no date on which you can assume a return of your capital. If the value of the fund is lower when you want to take your money out, you sell for a loss.
In a rising rate environment, the value of the bonds in the fund will decline – which will reduce the price of the fund.
“But wait – if I own the bond outright, won’t its value decline too?” you may ask.
Absolutely, it will. But that doesn’t matter if you plan on holding it until maturity.
Here’s what I mean: Let’s say you buy a corporate bond at par that yields 4%. It matures on October 1, 2022.
Every October and April, you will receive interest payments equal to 4% annually. Let’s assume that this time next year, interest rates have soared. And your bond that you paid $1,000 for is worth only $900.
You still receive your interest payments in April and October no matter where the bond is trading. Unless you are going to sell the bond, it doesn’t matter what the price is – because on October 1, 2022, you’re going to get $1,000 back.
It’s why I recommend that bond investors buy only bonds they plan on holding until maturity. If something happens where the bond goes up in price and you have a profit, you can decide to sell it. But assume you’re going to hold it until maturity.
Bond funds are a dangerous place to invest in a rising rate environment because they are practically guaranteed to lose money. Stick to individual bonds for the fixed income portion of your portfolio.