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Investing in a volatile bond market

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

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More than six years ago, the Federal Reserve moved its target fed funds rate to 0%, an unprecedented move, and just one part of a broad effort to keep interest rates low and stimulate the economy. Ever since then, some investors have worried about what would happen to bonds when the Fed reversed course and raised rates.

That day seems to be coming closer. With the U.S. economy improving and unemployment dropping, the Fed is weighing when to raise the key fed funds rate. At the same time, the markets have become more volatile.

What does this shifting investment backdrop mean for you? The answer depends on why you own bonds—and how sensitive you are to possible price fluctuations. Here are some of our recent insights on the bond market, the outlook for rates, and some strategies to consider, depending on your particular needs.

Fed policy and rates

  • Many analysts believe the Fed will raise the target fed funds rate in the second half of 2015 or early 2016, though the central bank has made it clear its decision will depend on economic data.
  • When the Fed does raise rates, it is likely to signal its intentions to the markets, and any changes are likely to be moderate in scale.
  • Long-term interest rates are a result of investor activity, and may stay low even after the Fed moves its benchmark short-term rate.
  • Bond markets have become more volatile in recent months and that could continue if global central bank policies continue to evolve.

The rate outlook

  • The Fed may raise its key short-term rate, which could cause rates on bonds to rise.
  • While rates may inch up, there are a number of reasons they may remain below long-term averages:
    • Rates on many non-U.S. sovereign bonds are low, creating global demand for U.S. Treasuries.
    • Supply of U.S. government bonds has diminished with the reduction of the U.S. deficit.
    • Aging baby boomers are demanding investment-grade bonds for income.
    • An older population has the potential to reduce America’s long-term growth potential.
  • Within the municipal and corporate bond markets, volatility is normal and rates will vary based on the outlook for particular issuers, regions, industries, and sectors.

What it means for investors

  • Generally, rising rates are bad for bond prices. Bond funds see their net asset value fall in price, and individual bonds and bond exchange-traded funds (ETFs) also see price losses.
  • But rising rates can create opportunities. Over time, funds should generate more income and if you invest over a long enough time period, the added income can help offset the price losses. Individual bond investors might 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 affected 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.
  • Bonds continue to serve as an important diversifier. 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 that is based on an investor’s horizon and objectives is more likely to generate favorable long-term outcomes.

Strategies to consider

  • Given the ever-changing investment landscape, it is important to review your bond holdings. Take a moment to use Fidelity’s interest-rate sensitivity tool and fixed income analysis tool, which can help you model the impact of a rate change on the value of your bond holdings.
  • 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, consider adding less traditional bonds to your mix, for example, high yield bonds. Be mindful that higher yields typically mean higher risk, so pursuing 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 real estate investment trusts (REITs), convertibles, preferred stocks, and dividend-yielding stocks.
  • If your primary goal is to minimize price losses if rates rise, consider short-duration bond products. Short duration bonds, bond funds, and CDs may offer a competitive yield relative to money market funds, though credit risk and interest rate risk are greater. At the same time, these investments may offer less price sensitivity to interest rate changes than longer-duration bonds and bond funds do. In a rising rate environment, short-duration funds may outperform longer-duration funds, in spite of lower current income.
  • If you are looking mostly to offset stock market risk, consider longer-duration high-quality bonds and bond funds. These investments will have interest rate risk—and prices may decline more than bonds and bond funds when rates rise. However, 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 if you 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 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 an attractive combinations of risk and return. They may offer less diversification benefits to offset your stock portfolio than a long-duration government bond fund does, but they may provide more total return potential and greater resilience to rising interest rates.
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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.
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. Interest income earned from tax-exempt municipal securities generally is exempt from federal income tax, and may also be exempt from state and local income taxes if you are a resident in the state of issuance. A portion of the income you receive may be subject to federal and state income taxes, including the federal alternative minimum tax. In addition, you may be subject to tax on amounts recognized in connection with the sale of municipal bonds, including capital gains and “market discount” taxed at ordinary income rates. “Market discount” arises when a bond is purchased on the secondary market for a price that is less than its stated redemption price by more than a statutory amount. Before making any investment, you should review the official statement for the relevant offering for additional tax and other considerations. The municipal market can be adversely affected by tax, legislative, or political changes and the financial condition of the issuers of municipal securities. Investing in municipal bonds for the purpose of generating tax-exempt income may not be appropriate for investors in all tax brackets or for all account types. Tax laws are subject to change and the preferential tax treatment of municipal bond interest income may be revoked or phased out for investors at certain income levels. You should consult your tax adviser regarding your specific situation.
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.
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