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Managing Your Fixed Income Holdings When Rates Rise

How Do Interest Rates Impact Bond Prices?
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Rob Williams, managing director of income planning at the Schwab Center for Financial Research, discusses interest rates, bond prices and bond ladders. 

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Janet:

Rising interest rates can mean different things for different people. For some investors, a rising-rate environment can create concerns about fixed income holdings. Rob Williams, managing director of fixed income and income planning at Charles Schwab, joins us to discuss the significance of rising rates on fixed income holdings in your portfolio.

You’re listening to the Insights & Ideas podcast brought to you by Charles Schwab. I’m Janet Alvarez. In this installment we’ll dig into how different bonds, and other fixed income holdings, perform during rising-rate environments. As Rob Williams explains, diversification may be the key to maximizing your returns.

Janet:

Hi, Rob, thanks for joining us today.

Rob:

Hi, Janet. Thanks for having me. Great to be here.

Janet:

So, Rob, our conversation today is about fixed income holdings, especially in a rising-interest-rate environment. Now, historically, some investors have been a little wary of fixed income holdings when interest rates are rising. Why is that? And is there really a sound rationale behind that?

Rob:

Well, the main reason is that if interest rates rise, fixed income or bond investments often can fall in value. That’s something we read a lot in the press and rightfully can be concerned. If interest rates go up we know that fixed income or bond investments tend to fall in value.

So that’s a concern that investors rightfully should be positioning for and at least be aware of as they’re thinking about their bond and fixed income investments as part of their portfolio.

Janet:

Rob, if I’m hearing you correctly, there’s a difference between the face value of a bond and its market price at any given time. Can you explain to us a little bit what that difference is?

Rob:  

Great question. So when we’re talking about the fluctuation of a bond’s value, we’re talking about the market price. That’s the value of an existing bond that you may own, and if interest rates change, that market value, if you sell it, try to sell it, can go up or down. The par or face value of the bond doesn’t change. It never changes.

It’s what the person that issued that bond and borrowed the money promises to repay you when the bond matures. So it’s important to know that fluctuations in the market value of that bond may be important if you need to sell a bond or you’re worried about the short-term value of it. But the face or par value doesn’t change. You’re promised to be repaid that amount, subject to the credit risk, ability to pay of that issuer, when the bond matures.

Janet:

Now, there are various classes of fixed income investments. Are there some that are more negatively impacted during a period of rising rates?

Rob:

Yeah, the most important thing to know is there are different characteristics of bonds or fixed income investments. And one of them is the maturity. So a bond or a fixed income investment is like a loan and think about it in terms of how long is it going to take for you to be paid back. So if you lend someone $100, it takes a certain amount of time before they’ve promised to pay you back. So that’s called the maturity of the bond.

And bonds and fixed income investments that have longer maturities or a longer time until you get your money back, those tend to be more sensitive or more exposed to changing interest rates. So those are the types that we talk about the most, at being at risk, you may want to think about when you’re managing your bond portfolio. And then short-term bonds, those that have shorter maturities, you get your money back faster, they tend to be less sensitive to interest rates.

Those are the two—sort of the main variable to consider when thinking about a fixed income portfolio.

Janet:

A bond ladder is a portfolio of bonds that mature at regularly staggered intervals. In other words, you might choose to hold bonds that mature at different times—such as in one, five or 10 years. This strategy not only provides income, but by offering regular opportunities to cash out at a bond’s face value, it can also protect against the price declines in bonds that typically accompany rising interest rates.

Janet:

Can you talk to us a little bit about bond ladders and how they would play into that diversification scheme?

Rob:

Right. Bond ladders are a great strategy, we think, for if you like to own individual bonds but want to manage interest rate risk. So a bond ladder is basically buying individual bonds that have staggered maturities—like a ladder. So think having a bond that matures in one year, maybe two years, three, four, five. Out to as long as you want. And what that can do is basically have bonds that are maturing soon, say in a year or shorter. So if interest rates go up, you can reinvest that money if interest rates change at higher rates.

Say a bond matures in your ladder, the bottom rung, and then you add it to the high end of the rungs, so you buy a new bond—say, over the longer maturity, 10 years or whatever the length of your ladder is. So what this helps you do is manage interest rate risk—the risk that interest rates may rise or fall—by hedging your bets and spreading out your investments over different maturities. So that’s what a ladder does. It’s a great strategy to help both time when you’re going to get money back from a bond portfolio, but also to help position yourself—if interest rates rise, you’ll have money to invest when you need it.

Janet:

Is it accurate to say that there is actually no single interest rate, in fact? And what would you say to investors who are concerned about the headline interest rate figure that they do hear in the press.

Rob:

That’s a really important point that we encourage you to think about. There’s no one interest rate. There’s multiple interest rates for different types of bonds, different types of loans. The Federal Reserve in the U.S. really controls most directly the short-term interest rate, the federal funds rate.

Interest rate on a 10-year Treasury bond generally sort of moves a little bit more with confidence about the economy and inflation. So there’s a lot of factors that professional managers think about when thinking about interest rates.

Janet:

Now, since the November election, there has been a selloff in the bond markets. Can you talk to us a little bit about some of the reasons for and the effect of that selloff?

Rob:

Sure. If you’ve been watching the markets recently, interest rates have risen pretty significantly in almost every area of the bond market since the election.

There’s many reasons for that, but some are potential deregulation in the U.S. economy; higher recent measures of inflation, which can cause interest rates to go up; the potential higher probability for tax reform and infrastructure spending. A lot of other factors that the bond markets are absorbing that new information since the election. So in response, some investors have been selling their bonds. And as a result, that’s caused rates to rise.

Janet:

During the month following the recent U.S. elections, a massive bond selloff led the Barclays Capital U.S. Aggregate Bond Index to drop by more than two percent. And investors may be worried that their bond portfolios will lose yet more value as rates rise. But it’s important to recall that same dynamic works in reverse when interest rates are falling. Rob also notes that if you own individual bonds, price fluctuations may not concern you—if the bond isn’t callable and you plan to hold it until maturity. Barring default, you’ll receive the same regular coupon payments and the same par value once the bond matures.

Janet:


And looking ahead, what sort of factors and events should bond investors pay close attention to in the next year?

Rob:


Well, with the election and with anything in the markets, the devil is kind of in the details. And we’ve absorbed a lot of details since the election, which has caused rates to rise somewhat. But there are still a lot of unknowns, and we’ll be watching those to see what kind of policy moves the new administration in the U.S. will be making. Also, factors to watch are the pace of economic growth.

If the economy is growing faster, that tends to lead to slightly higher interest rates. Investors are more confident in areas like stocks and may sell bonds to buy those investments. But really, this run-up since the election is really—this is an example of what we think is the most important thing, which is to really have a flexible investment plan. So we’ve seen rates rise, and certainly that’s been painful for some bond investors.

But over the longer term if you have bond ladders or use professional managers, they can take advantage of higher rates and generate more income and boost returns if rates rise.

Janet:


Rob, thank you very much for speaking with us today.

Rob:

Thank you.

Janet:

Rob Williams is managing director of fixed income and income planning at Charles Schwab. That’s it for this installment. The Insights & Ideas podcast is brought to you by Charles Schwab. You can find us on iTunes or insights.schwab.com.  If you enjoyed this episode, please subscribe and write a review on iTunes. For more information about fixed income investments and other subjects, you can read more at insights.schwab.com. Thank you for listening.

Important disclosures:

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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