Finance: Bond investor survival guide

PHUKET: It’s inevitable that interest rates will eventually rise, but what do rising interest rates mean for investors and how can you prepare your portfolio? First of all, here is what you need to consider or be concerned about:

INTEREST RATES AND BONDS

When interest rates rise, prices of fixed rate bonds will fall (and vice versa) because no one wants to buy a bond with a lower rate than what’s currently available in the market.

However, and if you own individual bonds until their maturity, you will not actually lose any money (unless of course the bond defaults), as what you lose is the ‘opportunity cost’ of owning a newer bond with a higher interest rate.

BOND FUNDS

Most investors own bond funds rather than individual bonds, and that can be a problem because bond fund managers are constantly buying and selling bonds. In general, and when interest rates finally rise, a bond fund investor’s principal will decline until interest rates stabilize or begin to decline again.

Moreover, bond funds holding long-term bonds in particular are more exposed to losses than short-term bond funds, which are less risky but also yield less to investors seeking income.

JUNK BONDS

High yields from so called ‘junk bonds’ are tempting in a low interest rate environment. However, there is a reason why some companies, and even governments, must issue bonds with above market interest rates, as these issuers could find themselves squeezed for financing or could go into
default when rates rise.

DIVIDEND-PAYING STOCKS

Low bond yields in many developed countries sent investors piling into dividend paying stocks – sending share prices up and dividend yields down.

A rise in interest rates could have some investors exiting these stocks or stock funds for high quality bonds that are guaranteed a certain return at maturity without the risk to principal associated with stocks.

EMERGING MARKETS

Most emerging market governments have issued a greater share of debt in domestic currencies, but rising US dollar interest rates tend to lower the attractiveness of investments in other currencies. This means that emerging market exchange rates along with stock and bond prices could take a hit.

While trying to ‘time’ the bond market or guess when, and by how much, interest rates will rise is also a risky strategy, but there are ways to protect your investment portfolio from rising interest rates.

LADDER YOUR BONDS OR BOND FUNDS

Individual bonds should always be held with ‘laddered’ maturities dates (1 year, 3 year, 5 year, 10 year and so on) to avoid the risk of every bond coming due in a low interest rate environment. This laddering can also be achieved to a similar degree by holding bond funds containing short, medium and long-term maturities.

DIVERSIFY YOUR BOND HOLDINGS

Besides holding bonds or bond funds of varying maturities, holding government, corporate, high yield (so-called ‘junk’) or emerging market issues either individually or via funds can be another way to lower long-term volatility and exposure to interest rate movements in either direction.

INVESTMENT GRADE SHORT-TERM BONDS

Risk adverse bond investors seeking more protection from rising interest rates might want to allocate a larger portion of their bond portfolio to short-term investment grade bonds and bond funds. Just be aware that the more allocated to short term and investment grade bonds, will likely mean lower returns over the longer term. My bond asset allocation model continues to show the longer term bonds entering a downtrend and focus more on these shorter term bonds.

Fortunately for bond investors, most analysts do not see a dramatic rise in interest rates for developed economies where economic growth remains relatively weak. And even if there is an unexpectedly high rate rise, it should be remembered that while 50% plus stock market declines have occurred, a loss of 10% or more during a one-year period for US investment grade bonds (or their equivalents) is an exceptionally rare occurrence.

However, my charts do show a bond market sell off and longer term yields are rising – meaning you or your investment adviser will need to take a very close look at your existing portfolio to understand how you could be affected.

Don Freeman,BSME is president of Freeman Capital Management, a Registered Investment Advisor with the US Securities Exchange Commission (SEC), based in Phuket. He has over 15 years experience working with expatriates, specializing in portfolio management, US tax preparation, financial planning and UK pension transfers. Call for a free portfolio review. Don can be reached at
089-970-5795 or email: freemancapital@gmail.com.