Your 401(k) and rising interest rates

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Q. After your story about the Fed, I have another question. What is likely to happen to my 401(k) value as a result of the Fed’s actions in selling? Let’s say I have 50 percent invested in an equity index fund and 50 percent in a bond index fund.
— Curious

A. Rising interest rates are what you can expect to see as a result of the Fed’s actions.

And for you, rising interest rates will probably have a negative impact on your bond index fund.

Take this example, offered by Gregory Chebuske, an Accredited Investment Fiduciary with U.S. Financial Services in Fairfield.

Imagine you invest $10,000 in a 10-year bond that pays 2 percent. Now imagine rates on 10-year bonds jump to 3 percent, and you want to sell your investment.

Could you sell your bond at its $10,000 face value? Absolutely not.

“Why would an investor pay face value for your bond when he could invest $10,000 in a new 10-year bond and earn 3 percent?” Chebuske said. “Instead, the bond’s value will go down to offset its lower interest rate.”

Conversely, he said, if interest rates were to fall after your purchase, the value of your bond would rise because investors cannot buy a new issue bond with a coupon as high as yours.

As if rising interest rates weren’t bad enough for bonds, if you are a shareholder in a bond fund during a period such as this, your pain will likely be greater than an investor invested in an individual bond, Chebuske said.

For example, he said, a given bond fund will hold hundreds, perhaps several thousand individual bonds.

“When interest rates rise, to avoid further losses, shareholders in a bond fund will liquidate their shares,” he said. “When this occurs, the fund manager may be forced to sell bonds prematurely in order to raise enough cash to meet its redemption requests.”

This can have a destructive effect on the value of your bond index fund, he said.

Chebuske said you may want to reduce the risk on your bond index fund by divesting into shorter-term bond funds. You may also want to divest a portion of your bond index fund into fixed income investments that historically do better in rising interest rate environments, such as Treasury inflationary bonds or floating rate funds, he said.

Rising interest rates can also have a negative impact on the equity markets, Chebuske said.

“Higher interest rates mean that consumers do not have as much disposable income,” he said. “The cost of borrowing will affect businesses and farmers, who also cut back on spending in the form of hiring and equipment — thus slowing productivity and the bottom line.”

With all that being said, Chebuske said it’s impossible to predict the markets and if you like your portfolio’s risk level, you should keep it.

“While rising rates do hurt bond prices, over the long term higher rates can boost the total return,” he said. “The reason is that a bond fund is always investing the interest payments from the bonds it holds as well as reinvesting the proceeds of maturing bonds in new bonds.”

When interest rates are rising, that money is being invested in bonds with higher yields, which eventually boosts the fund’s return, Chebuske said.

He said it’s important to maintain a diversified portfolio because holding different kinds of stocks, bonds and alternatives will usually perform better with less volatility over time than one concentrated asset class.

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NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.