NEW YORK (
TheStreet) -- Most investors know rising interest rates can undermine bond prices, but just how bad can it be? With rates likely to drift up this year, it's important to know.
While bonds do indeed perform poorly in this kind of environment, the damage isn't always as bad as many investors expect, according to a study by Morningstar , the market-data firm.
"The risk of rising rates is real and could be costly if the magnitude of the move proves large," Morningstar cautions. "And even if rates stay steady, bonds no longer benefit from the tailwind of falling yields, which spurred impressive gains since the 1980s. Nevertheless, we don't believe investors should jettison them from portfolios altogether."
The general effect of rising rates is easy to understand. If you paid $1,000 for a bond yielding 3%, it would pay you $30 a year. If, a year later, new bonds selling for $1,000 were to yield 6%, no one would pay the full $1,000 for your older bond. Its price would fall to $500, so its $30 annual payment would equal the same 6% paid by new bonds.That would be pretty devastating, but in real life other factors reduce the damage. For one thing, the possibility of higher rates may be worked into the price of a bond when you or your mutual fund buys it, so that the reality of higher rates has less impact later. Also, those $30 coupon payments could be reinvested in newer bonds with higher yields. diversifies a portfolio -- a benefit that survives when even rates are rising. But to strengthen the bond portion of a portfolio, Morningstar recommends a look at corporate bonds. Because they start with higher yields than government bonds, they may well be hurt less by rising rates. Another strategy, says Morningstar, would be to increase holdings of Treasury inflation-protected securities, or TIPS, a form of government bond that has periodic principal increases to keep pace with inflation. TIPS values can be undermined by rising rates, but not by the rising inflation that often accompanies rising rates. "Bonds still retain their utility as portfolio stabilizers, and prudent allocations to credit-sensitive and inflation-hedging sectors could help minimize damage caused by a rising-rate environment," Morningstar says.