For the first time since the Great Recession of 2007–09, the Federal Reserve has begun slowly raising interest rates. The first hike in the benchmark Fed Funds rate for overnight lending of reserve balances between depository institutions—from 0.25% to 0.5%—came in December 2015. A year later, on December 14, 2016, the central bank nudged up the rate again, from 0.5% to 0.75%. Most Fed watchers believe that the rate will ease upward again by mid-year 2017 and possibly once more during the current year.
One of the basics of fixed-income investing, of course, is that as interest rates rise, bond prices dip. That’s because the availability of newer bonds with higher coupon rates (the interest) tends to depress the value of older bonds with lower rates. Related to this is the fact that bonds with long maturities (10 years or more) carry a higher risk than bonds with shorter maturities, because the owner of long-term bonds would, in theory, have to wait much longer to replace them if interest rates were to go higher.
So, with interest rates edging upward for the first time since 2012, should fixed-income investors be buying short-term bonds? Should they be thinking about unloading their longer-term fixed-income holdings?
I have long advocated the value of relatively secure, fixed-income investments like bonds and bond funds as a part of my clients’ asset mix, particularly for older investors who cannot afford drastic reductions in either the income stream from their portfolios or the overall value of their assets. I tell them to think of the interest payments from their bonds as part of the “steady drip” into their pool of assets that can help the pool grow deeper instead of drying up. But even with a fixed-income portfolio, diversification is important. I counsel my clients not to put all their eggs in a single interest-rate or maturity basket. In other words, the way I help my clients balance the risk of changes in interest rates is by helping them maintain a balance among different maturity ranges: some short-term, some intermediate, and some long-term.
With the Fed signaling that additional—though probably cautious—rate hikes may be on the way, this could be a good time to slightly shorten maturities or to use funds available for investment to secure short-term bonds with maturities in the one- to three-year range. By doing this, investors may see reduced overall volatility in the value of their fixed-income portfolios as well as modest increases in total return (income received from the investments plus increases in value of the underlying asset) as compared to holding only longer-term bonds or bond funds.
As always, however, any repositioning of assets—fixed-income or otherwise—should only be undertaken with the help of a trusted advisor who has a thorough understanding of your financial goals and investment strategy: someone who can help you maintain proper diversification among your investments. Shortening your maturities doesn’t mean jumping ship; it just means making sure that the boat stays on an even keel.