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, 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:
- 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.
- 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.
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.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917