Lately the bond markets have been making headlines. It’s no secret that we, as a country, are in a historically low interest rate environment and, as a result, a lot of so-called “experts” are talking about rising interest rates in the near future. These experts usually go on to state that if interest rates begin to rise and you have bonds you could face substantial losses. Unfortunately, like many things in finance, this type of blanket statement is misleading because not all bonds are created equal!
First, let’s dissect their argument to understand why an investor might lose money in a rising interest rate environment. Bonds are typically issued by a government, a municipality, or a corporation. These entities need money for a variety of purposes and one way they can get that money is by taking a loan from investors. In exchange for an investor loaning that money to these entities, there is a promise to pay back the original loan amount (principal) as well as an interest rate paid on that principal over the life of the loan. The challenge and the risk to current bond investors is that if interest rates begin to rise, the traditional bonds they hold might not look as attractive to new potential investors. If you think about it, why would I, as a new potential investor, want your bond paying an interest rate of 3.5% when I can buy a new bond from the same company (or government/municipality) paying 4.5% today? Assuming all else is equal except the rate of interest, then I think the answer is pretty clear. It would be silly for me to purchase a bond paying 1% less.
So how does the bond holder with the unwanted 3.5% bond get rid of it? The answer is he has to sell it at a reduced price. This reduction in price is the big risk that experts keep referring to. It’s important for investors to remember that if you hold individual bonds you will get your principal back at maturity as long as the company stays in business and doesn’t default. Regardless of what your statement says the bond is worth at any given time, that value or number only applies if you choose to liquidate the bond at that exact point in time.
Hopefully, this very simplistic example helps you understand the inherent risks involved with more “traditional” bonds and a rising interest rate environment. As I said, not all bonds are created equal, and some types will probably benefit from a rising interest rate environment.
Floating Rate Bonds
It’s probably clear by now that the biggest issue, in a rising interest rate environment, is the fixed rate of interest that “traditional” bonds pay. If rates started to rise, and the interest rate on your bond rose along with it, then you probably wouldn’t have to discount your bond much, if at all.
So are there bonds out there that can rise as overall market rates rise? Yes! They are called floating rate bonds. A floating rate bond typically “resets” its interest rate annually, although some will reset more frequently. Because of this “reset” floating rate bonds can be a very attractive investment option when overall interest rates are projected to rise in the near term. Please keep in mind that floating rate bonds aren’t without risk of loss…the point is just that they typically maintain their secondary market value even when interest rates rise.
Now that you have read this, the next time you see the headlines that claim bonds are bad and to avoid them like the plague, you should have a good sense of what type of bonds they are referring to. Also, know that it is still possible to make money in bonds in a rising interest rate environment! Floating rate bonds may or may not be suitable for your portfolio. In order to make that determination you would need to perform a total portfolio analysis in coordination with your financial professional.
Matthew Trujillo, CFP®, is a Registered Support Associate at Center for Financial Planning, Inc. Matt currently assists Center planners and clients, and is a contributor to Money Centered.
As with any fixed income investment, there is a risk that the issuer of a floating rate investment will be unable to meet its payment obligations. In addition to the risk, floating rate bonds also face the following risks:
Reference rate risk: While the market value of a floating rate bond under normal circumstances is relatively insensitive to changes in interest rates, the income received is, of course, highly dependent upon the level of the reference rate over the life of the investment. Total return may be less than anticipated if future interest rate or reference rate expectations are not met. It is also important to note that since short-term rates are usually lower than long-term rates, the initial coupon of a floating rate bond is typically lower than that of a fixed-rate bond of the same maturity.
Call risk: A floating rate bond may be issued as either non-callable or callable. If a callable floating rate bond is called by the issuer prior to maturity, the investor may be unable to reinvest funds in another floating rate bond with comparable terms. If the floating rate bond is not called, the investor should be prepared to hold it until maturity.
The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Center for Financial Planning Inc. and not necessarily those of RJFS or Raymond James. C14-013999