September 25, 2022

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Should I Invest in Bonds as Interest Rates Rise?

Welcome to Select’s newest advice column, Getting Your Money Right. Financial advisor Kristin O’Keeffe Merrick will be answering your pressing money questions. (You can read her last installment here on how to diversify an investment portfolio to reduce risk and losses.) Have a question you want to ask? Send us a note at [email protected]

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Dear Kristin, 

I am a relatively new investor and have, up until now, only invested in stocks. I have been reading more about the bond market and am not sure if this is a good time to start investing in bonds now that interest rates have risen. Can you tell me more about investing in bonds so I can decide if it makes sense for me? 

Signed, 

Bondy in Baltimore

Dear Bondy,

This is an incredibly timely question and one that I have been answering for many clients recently. Before we get into it though, I need to provide some context about interest rates and how they correspond to bonds. 

Over the past 15 years, we have experienced historically low or falling interest rates. For many investors, this is the first time they have experienced a rising rate environment, so it is important to understand how this rise in rates can impact your portfolio in the coming months and years — especially since many of the strategies we have utilized over the past few years, with varying degrees of success, may not be as effective with this recent rise in rates. 

When interest rates rise, bond prices go down in value. Most bonds pay a fixed coupon (i.e. interest payment) and if rates go up, the only way a fixed coupon can equate to a higher interest rate is if the investor pays less for the bond. A bond’s duration is the measure of its price sensitivity in relation to a change in interest rates. Duration is a function of maturity, so the longer the maturity of a bond is, the longer its duration will be. The price of a longer-maturity bond is therefore more sensitive to a change in rates than that of a shorter maturity bond, assuming all other things are equal.

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With that in mind, let’s go back to my earlier point. If rates are going up and bond prices are going down, why would I want you to think about bonds? 

Firstly, bonds as a general asset class have a lower risk measure than stocks. Secondly, bonds generally pay you a coupon — monthly or quarterly, depending on the bond — that provides you with income as part of your investment. With interest rates on the rise, bonds will pay higher coupons. 

That said, bonds in general can be complicated and are not without risk. You need to consider interest rates and credit risk — how worthy the borrower or issuer is — before jumping in. 

If you look at shortening the duration of the bonds you own, it will help to limit the potential damage that can happen if interest rates rise. If you can attempt to remove the interest rate risk by hedging, bonds become much more interesting. 

There are investment strategies that concentrate on short duration, while others focus more on the products that hedge the interest rate of bonds,  which essentially mitigates the risk and makes the move in rates much less impactful. 

An example of an interest rate hedged bond strategy is when you invest in portfolios of investment-grade or high-yield bonds and include a built-in hedge to mitigate the impact of rising Treasury rates. In most cases, these products do their best to eliminate rate risk while short duration strategies only limit your exposure. You can also express this through asset classes such as floating rate investment grade bonds, bank loans and treasury inflation protected securities, or TIPS.

All of this can be expressed via exchange-traded funds, also called ETFs, and mutual funds. When researching which funds work best for you, consider the track record and expense ratios before making a decision. You should also consult with a financial advisor if you have one.

You will want to look for products that use the FTSE Corporate Investment Grade (Treasury Rate-Hedged) Index for investment grade bonds or the FTSE High Yield (Treasury Rate-Hedged) Index for high-yield bonds as a benchmark to help you make the right decision. 

You should also consider your equity portfolio when rates are on the rise. Just because interest rates are going up, it doesn’t mean you can’t still invest and make money in stocks. That said, not all stocks react in the same way in a rising rate environment, so it’s important to research this beforehand. 

Certain sectors such as financials have been historical over-achievers. Energy and materials have also done well due to the increase in prices (inflation) that comes along with rising interest rates. 

Personally, I have been focused on stocks that pay dividends. These types of stocks are generally lower in risk, are historically solid companies with long track records and have cash on hand to sustain market volatility — plus, they pay you dividends. 

There are many ETFs and mutual funds that focus on this kind of investing, which has many names, among them equity income or rising dividend funds. There are also ETFs you can buy that are solely focused on rising interest rates and the sectors and stocks that are most correlated with them.

This is a lot to take in as a new investor. My advice is to always do your research, ask questions and hire a financial advisor if this is too overwhelming for you. My other advice is to not become an expert in bond math — it’s truly the most boring thing in the world. Good luck!

If you do want to purchase bonds via mutual fund or ETF, consider using a brokerage that doesn’t charge commission fees, like Vanguard or Fidelity. Additionally a robo-advisor like Wealthfront or Betterment can construct a custom portfolio for you based on your risk tolerance, and generally they’ll include bonds in the mix of assets that they choose for you.

Wealthfront

On Wealthfront’s secure site

  • Minimum deposit and balance

    Minimum deposit and balance requirements may vary depending on the investment vehicle selected. $500 minimum deposit for investment accounts

  • Fees

    Fees may vary depending on the investment vehicle selected. Zero account, transfer, trading or commission fees (fund ratios may apply). Wealthfront annual management advisory fee is 0.25% of your account balance

  • Bonus

  • Investment vehicles

  • Investment options

    Stocks, bonds, ETFs and cash. Additional asset classes to your portfolio include real estate, natural resources and dividend stocks

  • Educational resources

    Offers free financial planning for college planning, retirement and homebuying

Betterment

On Betterment’s secure site

  • Minimum deposit and balance

    Minimum deposit and balance requirements may vary depending on the investment vehicle selected. For Betterment Digital Investing, $0 minimum balance; Premium Investing requires a $100,000 minimum balance

  • Fees

    Fees may vary depending on the investment vehicle selected. For Betterment Digital Investing, 0.25% of your fund balance as an annual account fee; Premium Investing has a 0.40% annual fee

  • Bonus

    Up to one year of free management service with a qualifying deposit within 45 days of signup. Valid only for new individual investment accounts with Betterment LLC

  • Investment vehicles

  • Investment options

    Stocks, bonds, ETFs and cash

  • Educational resources

    Betterment RetireGuide™ helps users plan for retirement

Vanguard

  • Minimum deposit and balance

    Minimum deposit and balance requirements may vary depending on the investment vehicle selected. No minimum to open a Vanguard account, but minimum $1,000 deposit to invest in many retirement funds; robo-advisor Vanguard Digital Advisor® requires minimum $3,000 to enroll

  • Fees

    Fees may vary depending on the investment vehicle selected. Zero commission fees for stock and ETF trades; zero transaction fees for over 3,000 mutual funds; $20 annual service fee for IRAs and brokerage accounts unless you opt into paperless statements; robo-advisor Vanguard Digital Advisor® charges up to 0.20% in advisory fees (after 90 days)

  • Bonus

  • Investment vehicles

    Robo-advisor: Vanguard Digital Advisor® IRA: Vanguard Traditional, Roth, Rollover, Spousal and SEP IRAs Brokerage and trading: Vanguard Trading Other: Vanguard 529 Plan

  • Investment options

    Stocks, bonds, mutual funds, CDs, ETFs and options

  • Educational resources

    Retirement planning tools

Fidelity Investments

  • Minimum deposit and balance

    Minimum deposit and balance requirements may vary depending on the investment vehicle selected. No minimum to open a Fidelity Go account, but minimum $10 balance for robo-advisor to start investing. Minimum $25,000 balance for Fidelity Personalized Planning & Advice

  • Fees

    Fees may vary depending on the investment vehicle selected. Zero commission fees for stock, ETF, options trades and some mutual funds; zero transaction fees for over 3,400 mutual funds; $0.65 per options contract. Fidelity Go is free for balances under $10,000 (after, $3 per month for balances between $10,000 and $49,999; 0.35% for balances over $50,000). Fidelity Personalized Planning & Advice has a 0.50% advisory fee

  • Bonus

  • Investment vehicles

    Robo-advisor: Fidelity Go® and Fidelity® Personalized Planning & Advice IRA: Fidelity Investments Traditional, Roth and Rollover IRAs Brokerage and trading: Fidelity Investments Trading Other: Fidelity Investments 529 College Savings; Fidelity HSA®

  • Investment options

    Stocks, bonds, ETFs, mutual funds, CDs, options and fractional shares

  • Educational resources

    Extensive tools and industry-leading, in-depth research from 20-plus independent providers

Kristin O’Keeffe Merrick is a Financial Advisor and money expert at her family-run firm, O’Keeffe Financial Partners, located in Fairfield, NJ. 

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