The hidden Risk of Rising Interest Rates

Many retirees allocate 60% or more of their portfolios to bonds, having followed the traditional mantra that fixed income securities are less risky investments than stocks. But what many are finding out is that with interest rates at historically low levels, the bonds they own may not be generating significant income and, in fact, may be hindering, rather than boosting, their portfolio’s total returns.   With money market instruments earning less than 0.5% and most long-term CDs earning less than 2%, the reputation of fixed-income investments as safe and reliable income generators has taken a beating in recent years.   Investors looking for a mix of credit quality and higher yields are having to seek out U.S. government and corporate bonds with maturities of ten years or more. But these long-term bonds carry risks as well. Should economic growth, rising inflation and reduced global demand for U.S. government bonds compel the Federal Reserve to raise interest rates in coming years, this will result in higher interest rates for new bonds and falling prices for existing bonds to make their relative yields more attractive. Long-term bondholders may end up losing money if circumstances require them to sell their bonds.  In this environment, investors may want to play it safer and look for CDs or bonds with maturities of six months to a year. While yields for these short-term securities will be lower compared to those of longer-term bonds, investors won’t have to wait as long (or potentially sell a bond at a loss) to reinvest their principal in higher-yielding bonds that may be available down the road.   If you don’t have the time or desire to buy individual bonds you may be better off investing in short to intermediate-term actively managed bond funds. Their portfolio managers are experts in buying and selling bonds to take advantage of different interest rate environments. But when comparing bond funds with similar characteristics and track records, you should closely scrutinize expenses and management fees. A fund with an annual return of 3% per year and 1.5% in annual fund expenses will deliver a net return for investors that is much lower than a similar fund or EFT that charges 0.75%. If you don’t feel comfortable doing this research on their own, you may wish to work with a fee-only fiduciary investment adviser. These professionals can objectively review your entire portfolio and recommend cost-efficient changes that will make all of your stock and bond investments work harder for your retirement.   Clarification: When Terry mentions that during times of rising interest rates when an investor with a long-term bond "is stuck earning a slightly lower yield for the remaining 10 or 15 years or the life of the bond," she means that that this bond's yield will be lower relative to higher yields that may be available from newly issued bonds or existing bonds that are now priced lower. When an investor buys a bond, its yield is locked in and will never rise or fall for as long as they own it.