Stocks are the primary driver of portfolio returns. Bonds are usually included for diversification and to reduce volatility. A portfolio with a higher percentage of bonds will likely be less volatile because of the limited stock market risk. However, more bonds mean more exposure to interest rate risk.
When interest rates go up, bond values drop. In a simple example, let’s say you bought a bond at $1,000 that paid 3.0% interest. If rates go up to 3.5%, investors will not pay $100 for your bond when they can pay that much for a similar one that pays 3.5%. The market will discount your bond’s value to a point where the two bonds offer a similar yield.
Fortunately, there are several strategies you can use to reduce your interest rate risk.
Lower Your Duration
Bond funds hold a lot of individual bonds with a variety of maturities. One of the most important measures to know about your bond fund is its duration. Duration is a measure of a bond investment’s price sensitivity to a 1% change in interest rates. If your bond fund has a duration of 6 years, you could expect to lose about 6% in value if interest rates go up 1%. However, if your bond fund has a duration of 3 years, you could expect to only lose about 3% in value. Lower duration bond funds will typically lose less money in periods of rising interest rates.
Duration to consider: 2-4 years
Unlike most bond funds, an individual bond will experience maturity (and repayment of your principal) at some point. The maturity value (par value) of a bond is typically $1,000. If you hold a bond to maturity, you can expect to receive $1,000 back and interest payments along the way. Interest rate increases may affect your bond’s value while you hold it, but they will not affect your par value. In the example in the introduction, if rates go up 0.5%, your bond value may decrease to $960, but if you hold it to maturity (and there’s no default), you’ll receive $1,000. Individual bonds only mitigate interest rate risk if they are held to maturity.
Consider building an individual “bond ladder” which means holding a set of bonds with staggered maturities. If you bought 8 bonds with maturities every 6 months, that would be considered a 4-year bond ladder. For retirees, a bond ladder can provide periodic cash/liquidity without incurring the interest rate risk of traditional bond funds. A short-term bond ladder can also be used by non-retirees to hedge against and take advantage of rising interest rates. They hold short-term bonds to maturity and then buy new bonds at higher rates.
Maturities to consider: 2-6 years depending on needs
Target Maturity Bond Funds
Target maturity bond funds are funds that hold a group of similarly maturing individual bonds to maturity. Funds can specialize in corporate, high yield, and municipal bonds. When all the bonds mature, the fund terminates and pays out its proceeds. This typically happens at the end of a certain year. For instance, a 2018 Fund will pay out its proceeds by 12/31/18.
These type of bond funds usually hold hundreds of bonds so they offer more diversification than individual bonds. If you don’t need certain maturity dates, it can also be easier to set up bond ladders using these funds since you wouldn’t need to pour over hundreds of individual bonds on a brokerage list. Target maturity bond funds, like other funds, have expense ratios, so there’s no guarantee that if you put $1,000 into a fund, you may not get back your full amount because of expense deductions.
Funds to consider: IBDH, IBDK, IBDL, BSCI, BSCJ, BSCK
More Cash and CDs
For the more risk-averse, holding fewer bonds and bond funds in lieu of money markets may help you sleep better at night. However, cash is not a long-term strategy, so have a plan for deploying your assets in the future.
CDs could be used as an alternative to individual bonds. CD’s are safer, but the trade-off is they provide a lower yield. CDs could also be used to complement a bond ladder. As an example, you may build a bond ladder maturing in 2-5 years. A CD ladder could be used for the shorter-term with maturities of 9-, 12-, and 18-months. This strategy could be very useful for retirees as they would have funds available to them at regular intervals.
High Yield Bonds
High yield bonds, or junk bonds, have a below investment-grade credit quality rating because of their higher default risk. They typically pay higher interest rates, so a small bump in rates usually doesn’t affect their attractiveness. In fact, it’s often argued that high yield bonds are more attractive in a rising interest rate environment. Higher interest rates indicate a stronger economy and therefore a better opportunity for issuing companies to meet their financial obligations (less default risk).
Short-term high yield bonds should not be a core holding, but can be a great complement to your bond strategy. High yield bond funds, whether traditional or target-maturity, are preferred over individual bonds as they offer more diversification and professional management in this challenging sector.
Funds to consider: SJNK, SHYG, BSJJ, VWEAX
Floating Rate Bonds
As the name implies, the interest rates of these bonds “float” or change with the market. When interest rates go up, the coupon rate on these types of bonds will adjust higher within a few months. This minimizes interest rate risk.
Floating rate bonds are also called bank loans because the loan is not issued directly from a firm to the investing public. Rather, a bank or similar financial institution extends a loan to a firm in need of capital. These loans are then packaged and sold to investors, like mortgages.
Floating rate loans are often associated with higher risk companies with a noninvestment-grade credit quality rating. These companies have indeed experienced more defaults. According to Moody’s Investors Service over the last 20 years, floating rate loans have had a default rate of about 3.2% vs. 0.1% for investment-grade bonds. One redeeming factor of floating rate loans is that they have seniority over other debt. In case of default, they typically have among the highest claims to a borrower’s assets.
The majority of floating rate bond funds are rated below investment grade, but there are a few rated as investment grade. These funds minimize interest rate risk and limit credit risk.
Funds to consider: FLRN, FLOT
Terry Green, CFP® is the owner of Blue Water Capital Management, LLC, a fee-only financial advisory firm in Apex, NC.