Will the Fed kill my bonds?
Q. I saw an article that said that when the Fed raises interest rates, there will be massive losses in the bond market. I’m retired and felt like bonds were conservative. When will the Fed raise rates and what should I do to protect myself? — Ted in Palm Bay
A. Ted, it would be a huge surprise if the Federal Reserve did not raise interest rates. The Fed has made clear its intention to do so to fight inflation. The exact size of the increase they will enact, how many increases there will be in the coming months, and the timing of the increases are all unknown and a favorite subject of the financial markets media. Whether the Fed’s actions lead to a sharp drop in your bond holdings is another matter altogether.
When interest rates rise, the market value of bonds declines. This interest rate risk is much greater for long-term bonds than for short-term bonds. There are other factors that affect the daily value of a bond, but this example will show you how changes in interest rates affect prices.
Suppose you had to pay $10,000 for a bond maturing at $10,000 in one year and paying 1% interest. In one year, you will get your $10,000 back when it matures and you will have earned $100 in interest.
Now imagine that a moment after the purchase of the bond, interest rates have reached 2%. This means that a new purchase of $10,000 will earn $200 in interest and after one year you will get your $10,000 back when due, but will have earned $100 in interest. Because a new bond would yield $200 and yours only $100, you couldn’t sell your bond for $10,000 when rates rose. The market value of the bond will drop.
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Because a buyer of your bond would only get $100 in interest, they would be looking at a purchase price of around $9,902. This would earn them $100 in interest plus $98 in appreciation, because the bond matures at $10,000. $198 in total earnings on a $9,902 purchase equals a 2% return.
In contrast, consider what would happen if your 1% bond matured in 20 years and interest rates instantly rose to 2%. This means that a buyer of your bond is obligated to receive $100/yr in interest for 20 years compared to buying a new bond which earns them $200/yr. As a result, the market value of your bond, the price at which you could sell it, will likely drop to around $8,200.
I won’t get into the math here, but a measure called “duration” will give you an idea of how sensitive your bonds are to changes in interest rates. Your 1% bond maturing in one year in my example has a duration of 1, while the 1% bond maturing in 20 years has a duration of about 18.
So Ted, if your bonds are of modest duration, the potential for losses from rate hikes is also modest. Also, note that with any bond, if you hold it to maturity, you get exactly what you paid for. On the day you bought either of the bonds in the example, you expected to get $100/yr and a value at maturity of $10,000. As long as the bond issuer doesn’t default, that’s exactly what you’ll get, even if the market value fell when rates rose.
The loss described may be paper loss but again it is easier to endure a paper loss if it is modest and will disappear in a relatively short period of time. Therefore, your best protection against rising rates and precipitous drops in value is to avoid too many long-term bonds.
What you need to do at this point is assess the duration of your bond holdings to ensure that the potential decline in market value due to higher rates is manageable.
I noticed you didn’t say your bonds had lost a lot of value in the last few months. This makes me suspect that your bonds may not be very long term. You see, on most maturities, rates have already increased in recent months.
It also highlights how obsessively obsessing over what the Fed is going to do and when may not be productive. The Fed only controls short-term market rates. Interest rates for all other periods vary according to market forces. Interest rates rose without the Fed changing the rates it controls. It is also possible that the rates at certain maturities will decrease after the actions of the Fed. We’ll see. If you have a smart strategy and a well-built portfolio, it doesn’t matter what the Fed does or when.
Dan Moisand, CFP®, is a past national president of the Financial Planning Association and has been featured as one of America’s top financial planners by at least 10 financial planning publications. He can be reached at www.moisandfitzgerald.com or 321-253-5400 ext. 101.