Interest rates aren’t expected to shoot up any time soon, but they can’t stay near record lows forever, and people closing in on retirement need to pay extra close attention.
The impact from an eventual rise in rates will vary from one investment to the next, but one thing is for sure: Soon-to-be retirees will want to take a defensive approach to any interest-rate sensitive investments, like bonds.
“You shouldn’t worry too much about rising interest rates because it means the economy is doing well,” says Mark Fried, president of TFG Wealth Management. “The biggest red flag is in the area of bond mutual funds. You have to be very careful to stay in shorter duration ones.”
When interest rates rise, the bond yield, or the amount of money you’ll make on your bond, declines. Fears that rates will rise and clobber bonds has been reoccurring concern since ringing in 2014.
Earlier this year, the markets were expecting a rise in interest rates, which resulted in lower bond prices. However, the exact opposite scenario happened: interest rate dipped. This move underscores the difficulty in predicting when rates will move and by how much.
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Continued record low rates have put many investors, particularly those in equities, at ease. After all, rising interest rates mean the economy is doing better, unemployment is improving and consumer confidence is on the upswing--all of which bode well for publicly-traded companies.
But bond investors aren’t out of the woods. Interest rates will eventually tick higher, which means bond investors should start playing defense.
“Every 1% increase in interest rates can devalue a bond by 10% to 15%,” notes Nicholas Yrizarry, president and CEO of Nicholas Yrizarry Wealth Management Group. Even talk of a quarter- point or half a point increase in interest rates can negatively impact the bond market, he says.
How much defense to play depends on an investor’s age. Those under 50 can worry less about the impact rates will have on their bond holdings because they have more years to invest. However, that doesn’t mean they should put all their money into bonds, warns money managers, it just means they have a longer window to recoup any losses.
But if retirement is on the horizon, you need to be careful with your bond selection. To avoid potential problems, money managers recommend staying away from long-duration bonds such as 30-year ones since higher interest rates are likely.
If you are looking for bond exposure, experts suggest investing in short and medium- term fixed-income products, preferably ones that don’t have a duration of longer than five to seven years.
Fried notes that anyone investing in a bond mutual fund needs to pay special attention to what’s included in the portfolio. “Lots of 401(k) investors like bond funds because they feel like it gives them a little safety, but I don’t think bond portfolios are providing safety within a 401(k),” says Fried.
Experts say if you are going to go with a bond fund, make sure to read the prospectus and understand the underlying bonds the fund is investing in before contributing any money. Fried claims that some bond funds report they invest in medium-term bonds, but are actually skewed toward short durations.
Risk-adverse investors are likely to scoff at the notion of putting their money in equities as a defensive play, money managers say there’s nothing wrong with the stock market, granted you follow a disciplined and diversified strategy.
“Bond prices have gone up and investors have almost made as much money in bonds in 2014 than they have in stocks,” says Maury Fertig, CIO of Relative Value Partners. “Right now is a good time to reassess their fixed-income holdings.”