Bonds and Short-Term
Interest Rates
In recent years,
interest rates have hovered near 40-year lows, easing the burden on borrowers
and creating a flurry of activity in the refinancing industry. Because inflation
has also remained low, the Federal Reserve has been able to maintain its
accommodative stance toward the economy and keep target interest rates at bay.
But as the economy improves, many people believe that short-term interest rates
will soon be on the rise. If this is the case, fixed-income investors may want
to develop an investment plan that takes advantage of fluctuating yields.
Extend Your Reach
Bond laddering is one technique that helps investors shield their portfolios
when interest rates are low and exposes them to greater growth potential when
interest rates rise.¹ This strategy involves splitting a bond investment to
purchase several different bonds with varying maturities. For example, an
investor might set up a ten-year bond ladder by buying five bonds that mature in
two, four, six, eight, and ten years, respectively. When the first bond comes
due after two years, the principal is used to purchase a new ten-year bond to
keep the ladder going.
The result is that, during periods of low interest rates, only a portion of the
investor's portfolio is committed to low-yielding bonds. And when interest rates
rise, money becomes available to purchase new bonds with potentially higher
yields.
Sell Wisely
Should an investor decide to sell a bond before it reaches maturity, rising
interest rates can affect its value on the open market. Bond values generally
move in the opposite direction of interest rates. For example, if you purchased
a $1,000 bond that paid 5% interest (or $50 a year) and decided to sell it at a
time when new bonds were offering 6% interest (or $60 a year), your bond would
be worth less to a prospective buyer. This is especially true for longer-term
bonds that lock in interest rates for longer periods of time.
Just as equity investors are subject to stock market whims, fixed-income
investors may find themselves at the mercy of fluctuating interest rates.
Keeping an eye on emerging trends may help you protect your portfolio and pursue
growth despite volatility.
1) The
principal value of bonds may fluctuate due to market conditions. If redeemed
prior to maturity, bonds may be worth more or less than their original cost.
