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Investing in a volatile bond market

Get our latest thinking on the market, the outlook for rates, and investment strategies.

Latest insights

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In recent years, falling interest rates and the Fed's commitment to economic stimulus have provided a tailwind for bond investors.

But last year, an improving economic outlook and changes in Fed policy led to rising rates—and new challenges for bond investors.

What does this changing market environment mean for you? That depends on why you own bonds—and how sensitive you are to possible price declines. But for most investors, bonds continue to play an important diversification role in the portfolio. Here are some of our recent insights on the bond market, the outlook for rates, and strategies to help, depending on your particular needs.

Low and rising rates

  • The Fed has begun to reduce the amount of bonds it purchases each month and begun to discuss the possibility of raising rates sometime in 2015.
  • As the market digested the changes in Fed policy, yield on the 10-year Treasury rose from 1.66% on May 2 to 3.03% at the end of the year.
  • Despite market reactions to the Fed’s comments, there are some reasons to believe the Fed itself will maintain low rate policies—and that rates could stay relatively low by historic standards. Those reasons include strong demand for bonds from an aging population and a still slow pace of economic recovery.

The long-term outlook

  • The markets have become volatile, and that may be a sign of things to come.
  • Investors should not expect bond funds to produce the double-digit returns seen in recent years.
  • Predicting interest rate changes has proven difficult and is not a key part of Fidelity's investment process. Nevertheless, there are reasons to believe that rate increases will be uneven, not sharp and sustained. Any sharp and rapid increase in rates would likely slow economic growth, and consequently, attract some investors back to fixed income.

What it means for investors

  • Generally, rising rates are bad for bonds. Bond funds see their net asset value fall in price, and individual bonds and bond ETFs also see price losses.
  • Rising rates could create opportunities as well. Over time funds should generate more income, and individual bond investors may be able to buy securities that offer higher yields. And as prices go down, some bonds may become undervalued.
  • Not all bond investments will be impacted equally. In general lower yielding, longer maturity and higher quality bonds have higher durations, and that means more price sensitivity to rising rates. For higher-yielding, lower-quality bonds that are exposed to the issuer’s credit risk, the improving economy signaled by gradually rising rates may benefit the financial health of certain non-investment-grade issuers enough to dampen the effect of rising interest rates.
  • We believe bonds continue to serve important functions as part of an overall asset allocation strategy. Most investors should avoid the temptation to tactically trade in and out of the bond market. Rather than trying to time the market, we believe that a balanced approach to asset allocation is more likely to generate favorable long-term outcomes.

Strategies to consider

  • For investors who intend to hold individual bonds to maturity, there may be no reason to change strategies due to rising rates. 
  • If your primary goal is income generation, remember that higher yielding funds tend to have greater exposure to interest rate risk, credit risk, or liquidity risk. So chasing yield can be risky—be sure to consider your time horizon and risk tolerance before investing in high yielding bond funds. Also, consider a diverse mix of bond and non-bond income sources including REITs and dividend-yielding stocks.
  • If your primary goal is to minimize price losses if rates rise, consider short-duration bond products. These funds offer a competitive yield relative to money market funds, though credit risk and interest rate risk are greater. At the same time, these funds may offer less price sensitivity to interest rate changes than longer-duration bond funds. In a rising rate environment, short duration funds may outperform longer duration funds, in spite of lower current income. 
  • If you are mostly looking to offset stock market risk, consider longer-duration high-quality-bond funds. These funds will have interest rate risk—and prices may decline more than other bond funds when rates rise. But, they may perform well in response to challenging economic conditions—when stocks may suffer. 
  • If your investment goal comes with a specific timeline, for instance saving for college, consider individual bonds or funds with a defined maturity. If you match the duration of your investments to your investment timeline and can keep your money invested until maturity, you may not have to worry about interest rate changes. A ladder of individual bonds or defined maturity bond funds may also help to balance interest rate risk, reinvestment risk, and current income. 
  • If you are looking for a balanced mix of income generation, volatility, and diversification, consider a broadly diversified bond fund. By including a wide variety of bonds, these funds seek attractive combinations of risk and return. They may offer less diversification benefits to offset your stock portfolio than a long-duration government bond fund, but they may provide more current income and greater resilience to rising interest rates.
Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.
Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Fidelity does not assume any duty to update any of the information.
As with all your investments through Fidelity, you must make your own determination whether an investment in any particular security or securities is consistent with your investment objectives, risk tolerance, financial situation and your evaluation of the security. Fidelity is not recommending or endorsing this investment by making it available to its customers.
Investors should determine which bond products are right for them based on their investment objectives, risk tolerance, financial situation and other individual factors, and re-evaluate them on a periodic basis. High yield/non-investment grade bonds involve greater price volatility and risk of default than investment grade bonds.
Past performance is no guarantee of future results.
All indices are unmanaged and performance of the indices include the reinvestment of dividends and interest income and are not illustrative of any particular investment. An investment cannot be made in an index.
Barclays Capital Aggregate Bond Index is a market value–weighted index of investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage-backed securities, with maturities of one year or more.
Diversification/asset allocation does not ensure a profit or guarantee against loss.
In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds and ETFs do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible. Any fixed income security sold or redeemed prior to maturity may be subject to loss. High yield/non-investment grade bonds involve greater price volatility and risk of default than investment grade bonds. Increases in real interest rates can cause the price of inflation-protected debt securities to decrease. The municipal market can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Interest income generated by municipal bonds is generally expected to be exempt from federal income taxes and, if the bonds are held by an investor resident in the state of issuance, state and local income taxes. Such interest income may be subject to federal and/or state alternative minimum taxes. Investing in municipal bonds for the purpose of generating tax-exempt income may not be appropriate for investors in all tax brackets. Generally, tax-exempt municipal securities are not appropriate holdings for tax advantaged accounts such as IRAs and 401(k)s.
Changes in real estate values or economic downturns can have a significant negative effect on issuers in the real estate industry.
ETFs may trade at a premium or discount to their NAV and are subject to the market fluctuations of their underlying investments.
Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.
Foreign markets can be more volatile than U.S. markets due to increased risks of adverse issuer, political, market or economic developments, all of which are magnified in emerging markets.
1. Performance from Oct. 1981 through Apr. 2013. Source: Morningstar EnCorr, Fidelity Investments (AART) as of Apr. 30, 2013.
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