There is a general public misperception about the connection between interest rates and the bond market, with many people believing that rising interest rates mean rising bond values. That’s not necessarily the case.
Bob Wamhoff, President of Wamhoff Financial Planning and Accounting Services, explains to Elliot Weiler.
If interest rates rise, bond values go down:
- The value of bonds you currently hold in your portfolio do not rise along with interest rates.
- In fact, the exact opposite happens. The value of currently held bonds actually goes down.
- This happens because when interest rates are higher than the rate of the currently held bond, that bond would be traded at a discount because of the lower yield it produces.
- In essence, someone would have to pay less for a bond (with a higher interest rate) to achieve the same dollar amount of return on a bond with a lower interest rate.
- On the flip side, if interest rates fall, bonds with higher interest rates would be worth more.
Unfortunately, we’re already at zero so there is no place to go except up, and the Fed has indicated that they will be raising interest rates. That means bond values, on currently held bonds, will fall.
Bonds can lose value:
- As demonstrated above, if interest rates rise and your bond is sold, it will be worth less than you paid for it because of its lower rate of return.
- Also, the lower interest bonds can pose a problem because the rate of return isn’t keeping up with the rate of inflation.
- Therefore, there is risk involved in investing in bonds. This is contrary to popular belief that bonds are risk-free or have much less risk than other investments.
Tips to consider when investing in bonds:
- Bonds offer a way to diversify outside the market.
- Consider the overall interest rate trend when investing in bonds – if interest rates are rising, you may want to opt for shorter term bonds to mitigate the risk.
Actively manage your portfolio, or have a professional do it for you, because in today’s bond market, the old buy and hold strategy may not be the best route for you.