Editors' Pick: Originally Published Monday, Dec. 14
Bond investors haven't had to worry about higher interest rates for nearly a decade. But now that the Federal Reserve has raised rates, it's worth exploring what you should do about it.
Keep in mind that the Fed's first rate hike doesn't really change much. Rates are still at historic lows. It all depends on how much the central bank raises rates in the coming months. So you don't have to rush to do anything.An increase of 0.25 percentage point on Wednesday didn't result in big swings in bond values. And the Fed reiterated that the pace of future increases will be slow.
Still, higher rates lessen the value of the bonds you currently own. That's because newly issued bonds under those higher rates will pay out more than older ones. So the price of your older bonds falls as a result.
But not every bond in your portfolio is the same. Bonds are designed to pay investors in proportion to the risk they take. The lower the risk, the lower the interest paid. But higher-risk, higher-paying bonds -- which many investors have embraced in recent years to get more yield -- stand to lose money, at least in the short term.
For investors who hold bonds primarily for the income they generate, the drop in prices doesn't matter as much. That's because if you hold a bond until maturity, you never have to sell it and take a loss.
Other Rising Rates Stories
- Fed Raises Interest Rates for First Time in Nearly 10 Years
- How to Play the Fed's Interest Rate Hike in 2016
- It Will Be Years Before We Know If the Fed Got It Right
- New Chapter Begins as Fed Acts on Rates
- What Happens When Interest Rates Rise
- Bill Gross: Why Low Rates Are Dangerous
- More Rate Hikes May Be Coming in 2016
- Banks Face Rising Demands from Consumers
- How Higher Rates Affect Your Retirement Portfolio
- Housing Market Will Survive Higher Rates
But it's a different story if you hold bonds through a mutual fund, as most investors do. The value of the fund declines with any interest rate hike because the fund becomes less attractive to investors.
The drop in value is closely linked with the term of the bonds, known as duration. Those durations are usually indicated as short term, intermediate term, or long term. In theory, short-term bonds will drop the least in value, and long-term bonds will drop the most when rates continue to go up.
So what should investors do?
Larry Swedroe, author of The Only Guide to a Winning Bond Strategy You'll Ever Need, urges investors not to make big moves without making a plan first.
"Inaction is almost always better" than making a sudden shift in strategy in a panic, he said.
"The most anticipated event of any we can think of is that the Fed is going to raise interest rates on Dec. 16," Swedroe said on Dec. 11, just before the rate hike. "The market must already have that information incorporated into the current price" of bonds (and stocks too, for that matter).
Don't try to outsmart the market, said Swedroe, who also is director of research for the BAM Alliance of financial advisers.