It’s been approximately a decade since the Great Recession began. By year-end 2008, the Fed had lowered the target federal funds rate to almost zero and embarked on an aggressive quantitative easing campaign. Now, after several years of economic recovery, the Fed has begun to reverse course, restoring its policies and targets closer to historical “norms” through quantitative tightening and gradually rising interest rates. As an investor, what can you or should you do to prepare if rates continue to rise? Or for that matter, if they don’t?
First off, it is important to understand the relationship between the price of a fixed income (bond) investment and interest rates. As interest rates rise, the price of fixed income instruments tends to decline. After all, assuming the term and the credit quality of two bonds is the same, a bond with a 5% coupon is less valuable than a bond with a 6% coupon. So, if the Fed continues to raise interest rates, it is very likely that you will temporarily see the value of your fixed-income investments go down.
As alarming and exciting as bond market news may become, it should provide comfort to know that, compared to stocks, the level of volatility and degrees of risk inherent in bond investing should not be as extreme as we must tolerate in equity investing. When reading bond market headlines about interest rates, yield curves and credit ratings, term risk (the term of the bond or how long the loan is outstanding) and credit risk (how likely the borrower is to be able to repay the loan) are the two risks that are rising or falling along with the news.
So where does this leave you as a long-term investor? First off, you should be sure that you are using the right kind of fixed income holdings in your portfolio. Just as there are various kinds of stocks, there are various kinds of bonds, with different levels of risk and expected return. Keep in mind that the main objective of fixed income investments is to preserve wealth; it is not to stretch for significant yield. As such, consider utilizing high-quality, short-to-intermediate term bonds that are issued by high-credit quality borrowers. Second, be mindful of the costs you are incurring as it relates to your fixed-income investments. These costs may be expressed by expense ratios for mutual funds and as “markup” and “markdown” costs (which can often be difficult to ascertain) for individual bonds.
Whether interest rates are rising, falling or standing still, we urge you to look past breaking news and fickle forecasts and to concentrate your efforts and energy on what you can control. Focus on your personal goals, ensuring that your portfolio stays optimized to give you the best chance to meet your objectives while also keeping your risk at a level you are comfortable experiencing. Focus on keeping costs to a minimum. For stocks and bonds alike, these are the most reliable principles for navigating uncertain markets.