16 May Should I buy bonds now that interest rates are higher?
Q. Now that interest rates are going higher, should I buy more bonds? Or should I wait until the Fed raises rates more?
A. There’s a lot to consider when it comes to adding bonds to your portfolio.
Lots of people are taking notice, as you are, with higher interest rates. In fact, I bonds, which are supposed to be an inflation hedge, are paying a record 9.62% interest rate.
But whether and when to buy bonds depends more on your age, risk tolerance, goals and needs than it does on the near-term direction of interest rates or inflation, said Gene McGovern, a certified financial planner with McGovern Financial Advisors in Westfield.
Before turning to your question about timing, let’s briefly review some bond basics.
Bonds come with numerous features and in many varieties, but at bottom, all bonds are debt instruments, McGovern said. The bond issuer borrows money from the bond buyer, usually in exchange for periodic payments of interest, at a fixed percentage rate, called the bond coupon.
Each bond has a maturity date — for example, 30 years — at which time the issuer must repay the original amount borrowed, also called the bond principal, he said.
Bonds are issued by several types of entities. These include the federal government and its agencies, U.S. corporations, state and local governments, and foreign governments and corporations, he said.
Bonds also differ greatly in their maturity dates and in how risky they are.
In general, bonds are classified as short-term, which mature in one to three years; intermediate-term, maturing between three and 10 years; and long-term, maturing between 10 and 30 years, McGovern said.
“Investing in bonds is generally considered safer and less volatile than holding stocks,” he said. “If you buy a bond and hold it to maturity, and assuming the bond issuer is creditworthy, you’ll receive the scheduled interest payments over the life of the bond and then get all your principal back at the maturity date.”
But still, bonds are subject to a number of risks, such as rising interest rates and inflation.
“As interest rates rise, the value of existing bonds that have lower interest rates falls,” he said. “Those lower bond prices, in turn, increase their yields.”
He offered this example: Assume that you bought a 10-year bond for $1,000 that pays 2 % interest, or $20 per year. If interest rates on similar new bonds rise to 3%, the value of your bond, assuming you wanted to sell it, would fall to about $914, or by roughly 8 to 9%.
Similarly, bonds this year have fallen around 10%, their worst returns in decades, he said.
“The price decline has been driven by rising interest rates and rapidly increasing inflation, which erodes the value of bonds’ fixed income payments,” McGovern said. “At the same time, as prices have fallen, bond yields have increased dramatically.”
In any event, if you hold an individual bond, you’ll get your principal back at maturity, so the drop in price matters only if you want to sell it now.
Exchange-traded funds and mutual funds that invest in bonds, by contrast, don’t have maturity dates, but they continuously reinvest in new issues as older bonds in the fund mature, which gradually increases their yields in a rising interest rate environment, offsetting the price declines, he said.
Over time, then, long-term bond investors benefit from the higher yields, which constitute most of bonds’ returns, he said.
Now to your question.
The Federal Reserve has just raised short-term interest rates by half a percentage point, and it’s widely anticipated that more rate increases are in store over the balance of 2022 and into 2023, McGovern said.
Keep in mind, however, that the Fed controls only short-term rates.
“The federal funds rate that the Fed just increased is the rate that’s used for overnight lending between U.S. banks,” he said. “That rate, in turn, affects the prime rate, which influences the rates that consumers pay for such things as auto loans and home equity lines of credit.”
Longer-term rates, though, are largely set by the market.
For example, McGovern said, while the federal funds rate target is 0.5 to 1%, the yield on 10-year Treasury bonds is now over 3%, while 30-year mortgage rates have risen to more than 5%. In other words, the market has already priced in expected interest-rate increases and inflation rates, he said.
As a result, whether to buy bonds now or wait until the Fed raises rates further isn’t really the best question. Over time, no one can predict the direction of interest rates or inflation, just as no one can predict stock prices, he said.
“A better approach is to set a long-term strategic asset allocation among stocks, bonds and cash for your investment portfolio as a whole, and to periodically rebalance to maintain it,” he said. “Your overall asset allocation should be based on your goals, needs, risk tolerance and time horizon.”
For example, a 25-year-old investor just starting out may be best off with a growth-oriented portfolio that’s 90% stocks and 10% or less bonds and cash, he said. By contrast, an investor just entering retirement at age 65 is often best off with a bond allocation of 40 to 50% of the portfolio, while an investor at age 85 may want to have about 60 to 70% in bonds, he said.
“While bonds provide interest income to investors, they also play a key role in providing ballast for a portfolio,” he said. “Although bonds have fallen sharply in value this year in tandem with stocks — an unusual occurrence — they’ve historically often had a negative correlation with stock prices, rising in price when stocks fall.”
U.S. Treasury bonds have been especially effective as a diversifier in reducing risk, he said.
“In the end, setting and maintaining the overall allocation to bonds in your portfolio is far more important than trying to time your bond purchases,” McGovern said.
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This story was originally published on May 16, 2022.
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.