When interest rates rise, as is happening now at an accelerated pace, bond prices fall. But that doesn’t mean you should avoid bonds.
You may have read that bonds have performed poorly as the Federal Reserve tightens monetary policy. That’s only half the story. Credit quality in the U.S. is strong — defaults are rare. Nearly all bond issuers are making interest payments on time.
Holding a portion of your portfolio in bonds is actually a way to cut risk. That may sound counterintuitive but read on. Explained below are strategies that can help you mitigate the risk of bond investments, even though the current interest-rate cycle will likely push prices down.
The mechanics of bonds
Bonds’ market values have declined. What does that mean to you? If you hold a bond and plan to keep holding it until it matures, the decline in market value doesn’t change the fact that you will receive the face value when it matures.
If you purchased a bond at a discount (for less than the face value), you will have a gain when it matures. Vice-versa if you paid a premium for your bond. The day-to-day price fluctuation doesn’t affect the payout at maturity. You continue to receive interest until the bond matures.
But if you own shares of a bond fund, your share price has been declining. But the interest is still flowing, and as bonds mature in the fund, they will be redeemed at face value and replaced with higher-paying (or higher-yielding) bonds. That eventually helps the share price to recover. How much does the decline in your bond fund’s share price bother you?
With inflation running at a 40-year high, it may take a long time before the upward direction of interest rates (and consequent decline in bonds’ market values) reverses. Can you wait? How long might you have to wait?
If you have money to invest, bond-fund or individual bond investments have already become more attractive with higher yields.
A case for bonds
A traditional model for stock- and bond-market exposure is called 60/40, with 40% of a portfolio invested in the bond market either though individual holdings or shares of bond funds.
The notion of a 60/40 portfolio seemed antiquated during the long period of declining interest rates, when stocks have produced some of the best performance in decades.
Central banks’ stimulus, low interest rates and very low (or even negative) yields for long-term bonds have pushed money into U.S. equities. The S&P 500 Index’s
average annual return (with dividends reinvested) for the …….