Bonds: Interest Rate Risk
When interest rates rise, bond values decrease. Let’s say you bought an individual bond that was paying 3% for $1,000. If interest rates increase to 3.5%, people can now pay $1,000 to get a bond that pays 3.5%. No one wants to pay $1,000 for the 3% bond, so it’s price (value) will drop until it is comparable to other bonds.
Bonds are usually initially issued at par (either $100 or $1,000) and they mature at par. Between issuance and maturity, there will be fluctuation in prices. Prices below par are said to at a “discount” while prices above par are considered to be at “premium”. In the example above, the 3% bond was issued at par but is currently trading at a discount. Even though that is the case, the owner of the 3% bond would still get their $1,000 back if they held to maturity, since it matures at par. However, if the owner had to sell the bond prior to maturity, and it was still priced at a discount, they would not get their full $1,000 back. So, one strategy is to buy and hold individual bonds, but there are others.
- Individual Bonds: There is risk with individual bonds because you may only be able to buy a few bonds for the bond portion of your allocation. However, you can really home in on the specific maturity, credit rating and yield you’re looking for. When you buy an individual bond, you know the return you will receive on your investment (barring a default).
- 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 example, the iShares iBonds Dec 2023 Term Corporate Bond ETF (IBDO) has a maturity around mid-December 2023.
Target maturity bond funds typically hold several hundred bonds, so they are a lot more diversified than just owning a handful of individual bonds. While you can buy several bond funds, each with a different year maturity, they don’t offer the flexibility that individual bonds do when it comes to picking maturity timeframes. 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 would get back the full amount. Another thing affecting the payout at maturity is that a lot of the bonds in the fund were bought at a discount and premium (remember, they will mature at par). If the fund had more bonds bought at a premium, you may not receive your full investment back at maturity.
- Floating Rate Bond Funds: 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 non-investment 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.
Many floating rate bond funds are rated below investment grade, but there are a few rated as investment grade, and those are the ones we prefer. Investment grade floating rate bond funds can help minimize interest rate risk and limit credit risk.
- Use Shorter-Term Bonds: 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. In periods of rising interest rates, lower duration bond funds can help lower your interest rate risk since they typically lose less money than higher duration bond funds.
- Increase CDs & Cash: CDs could be used as an alternative to individual bonds. CD’s are safer and have similar yields at short-term maturities, but often have lower yields at longer-term maturities.
For the more risk-averse, holding more money markets in lieu of bonds and bond funds may help you sleep better at night. However, cash is not a long-term strategy, so make sure to have a plan for deploying this money in the future.
- Income Ladder: An Income Ladder is simply a collection of individual bonds, CD’s, and/or target maturity bond funds with varying maturity dates (ex. bonds with maturities every 6 months for the next 5 years). An Income Ladder could be used in place of traditional bond funds if interest rate risk is a concern. Ladders can also be very useful for retirees as they would have funds available to them (liquidity) at regular intervals.