With interest rates at extremely low levels, some financial advisors say bond investments currently present a more significant risk to investors than stocks. As the economy recovers, the Federal Reserve may at some point have to raise interest rates, which will inversely affect bond prices. Long-term bonds tend to lose the most value during interest rate increases so many financial advisors have been reducing their holdings in this area and instead avoiding bonds or only recommending bonds that have shorter-term maturities.
An important piece of information for bond investors is a statistic known as “duration.” In finance, the duration of a financial asset that consists of fixed cash flows, for example a bond, is the weighted average of the times until those fixed cash flows are received. Duration also measures the price sensitivity to yield, the percentage change in price for a parallel shift in yields. Simply said, the longer the duration, the more sensitive a bond is to changes in rates.
Interest rate risk can be simplified by the following statement: when interest rates rise, bond prices fall; conversely, when rates decline, bond prices rise. Therefore, the longer the time to a bond’s maturity, the greater its interest rate risk.
Many investors often put a high percentage of their portfolios in bonds when they are very worried about the economy or other financial issues, or after they have taken a beating in stocks. Eventually that concern subsides over time, only to be replaced by greed. That is when investors often spurn fixed income investments and start buying back stocks. Then, when another market cycle ends, they many times get nervous again—and the fear-greed see-saw repeats itself.
So what should the prudent investor do?
Now is an ideal time to review, or revisit your portfolio holdings to identify what if any changes you may need to make. Over the next few days we will go over three basic strategies to consider discussing with your financial advisor to prepare for rising interest rates.
If you are interested in having a detailed portfolio analysis, you may qualify for a free Second Opinion Meeting with Jim. Call Alice at our office at 412-521-2732 to see if you qualify and to schedule an appointment.