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4 strategies for rising rates

When rates rise, not all fixed income investments have the same reaction.

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From 2008 through 2012 investors poured more than $1 trillion in net flows into bond mutual funds, while pulling more than $250 billion from stock funds.1 But bonds and bond mutual funds are not without risks—including one worth paying particular attention to now: interest rate risk.

The federal funds target rate currently is between 0% and 0.25%—its lowest level ever. But recent comments from some members of the Fed have made investors concerned that rates may start to rise soon. That doesn't mean rates will go up tomorrow—indeed, many of our fixed income experts believe they could stay low for a long time. But they won’t stay low forever, and investors need to understand the risks that exist when they rise.

Most fixed income investments are sensitive to interest rate movements: When rates rise, the prices of bonds generally fall. The good news is that not all bonds are created equal. Some types of bonds typically fare better than others during periods of rising rates—and the same goes for bond funds. The key is understanding why you own fixed income in the first place, and how to put together a mix of fixed income investments that can help you weather a period of rising rates—or potentially even prosper from them.

Why duration and credit spread matter for interest-sensitive bonds

While rising rates generally aren't good for bond prices, the total return for different types of bonds and bond funds can vary widely. There are a number of factors involved, but when trying to assess the impact rates will have on a potential investment, you may want to watch these two metrics:

  • Duration—a measure of a bond's price sensitivity to changes in interest rates.
  • Credit spread—the amount of additional yield a bond is paying compared with a Treasury bond with similar characteristics, due to the increased default, currency, liquidity, and market risk, or to other risk factors.

Short-term bonds generally have shorter durations and are less sensitive to movements in interest rates than longer-term bonds. You can buy bonds that mature in a few days or in 30 years. If rates rise, the interest rates on bonds with a longer maturity are locked in at a lower rate for a longer period of time. As a result, their value to buyers—i.e., their prices — tends to get hit harder when rates rise. Bond funds also vary based on the average maturity of individual bonds in the portfolio—and are subject to the same principles.

When it comes to credit spread, an issuer's level of credit risk is one factor that determines the interest rate it must pay on its bonds. Typically, higher-risk bonds pay more interest, or "coupon," and when market interest rates rise, the higher coupon can help protect the investor's total return from a price loss driven by rising rates, as long as the economic outlook for the issuers of those bonds remains positive and issuers are likely to continue paying their obligations.

Additionally, high-yield bonds may also experience some price support if the business that issues the bonds grows stronger. Rising rates have often accompanied an improving economy. Those economic improvements may benefit the issuer of the bonds, and that can lead to better performance for the bonds, helping to offset the damage from rising rates, as the performance of high-yield bonds during the rising rate period from 2004 to 2006 shows. (See chart to the right.)

Of course, credit conditions and the economic outlook for issuers won't always be improving. In 2008 when the financial crisis hit, high-yield bonds produced a loss of 26.39%, while the Barclays Aggregate Bond Index produced a cumulative gain of 13.74%.2 So if you are considering taking on more credit risk, you should remember that worsening credit markets can decrease higher-risk bond prices and total returns, regardless of interest rates.

Strategies for managing rising rates—bonds and beyond

So, the investing implications seem clear: Rising rates pose a challenge for bonds in general. But how should you react? For some investors, a little patience may be all that's required. Interest income can contribute a lot to fixed income's total return over time, so an investor who uses bond funds or a ladder will see an increase in income in a rising-rate environment as bonds mature and funds are reinvested at higher rates; that can potentially help to offset a short-term price drop—if your perspective is long enough. If not, using short-duration and higher-credit-risk fixed income investments may help reduce the impact of rising rates provided you are comfortable with the increased credit and default risk. You may even go beyond bonds in thinking about how to protect yourself from rising rates and inflation. Here are strategies to consider.

1. Maintain diversification despite the risks

For many investors there are good reasons to stick with bonds no matter what the interest rate outlook may appear to be. For one, no one really knows where interest rates are going or when. And two, many investors own bonds because they can help reduce overall volatility in a diversified portfolio. That's because the prices of many types of bonds have historically moved inversely with stock prices and fluctuated within a narrower range of highs and lows. So while rates are rising, bonds might lag stocks, but it may make sense to accept underperformance from that portion of your portfolio for the benefits of bonds when and if the environment changes and stocks struggle. For instance, when interest rates fall, as they did in 2008 and 2009, longer-maturity bonds may help sustain your portfolio's return.

What's more, while the price [net asset value (NAV) for funds] of bonds or bond funds may decrease, the bonds should continue to make the same interest payments, assuming they don’t default or get called. And, as the bonds mature or are sold, they can be replaced with higher-yielding bonds, which could create more income. That could limit or decrease any price losses.

If you have a long-range outlook, a solid asset allocation plan, and plan to hold your bonds to maturity, sticking to your current stock and bond mix may be a strategy worth considering.

2. Shorten duration

Let's say you have a nonretirement goal with a shorter investing timeline—like paying a college tuition bill for which you need a lump sum in less than four years—and cannot afford much risk to the value of the principal. Or maybe you are already living on a fixed income, investing in bonds to create income. Or maybe you can't stomach the thought of adding risk to you portfolio.

Choosing high-quality bonds or bond funds with shorter durations can help to mitigate the effect of rising rates. These bonds typically pay less than longer-term bonds and riskier bonds—so their low yields may not be right for investors with longer time frames. But these bonds do mature more quickly, allowing you or the fund manager to put that cash into higher-paying bonds sooner, helping to manage one of the challenges of rising rates.

For a lump-sum goal that's two years away, or less, you may want to consider short-term investments such as an FDIC-insured savings account, a short-maturity FDIC-insured certificate of deposit (CD), or a money market mutual fund, whose yield will tend to follow the federal funds rate closely. An exceptionally short-duration bond fund with high-quality holdings is another potential solution.

Or, build a "ladder" of short-term CDs by creating "rungs" of three months, six months, and twelve months, for example. You may have an opportunity to capture higher yields as you roll over the maturing securities. If you will be in the market a little longer, you may want to consider short or ultra-short duration bond funds, or you could build a longer bond ladder.

3. Accept more risk for higher interest potential

If you can tolerate greater credit risk and volatility, consider investment-grade or non-investment-grade corporate bonds. Despite periods of dramatic price changes, over the long term their relatively high income has contributed the most to their historic overall return. (Remember, past performance is no guarantee of future results.) Given the inherent credit risk associated with these types of bonds, it's important to diversify across many different issuers from different industries.

There are many ways to invest in the corporate bond asset class, including through mutual funds, exchange-traded funds (ETFs), or directly, through individual bonds. You can also construct a longer-term bond ladder. Each method of investing has strengths and weaknesses that you should consider carefully before making your choice.

Beyond traditional bonds, there are other income options. Consider real estate investment trusts, or stock/bond hybrids like convertible bonds, preferred shares, and dividend-producing stocks. Each can have unique risks, and aren’t right for everyone, but they may be worth investigating.

  • Learn more about fixed income options as well as non-bond income-producing alternatives.

4. Look for products that adjust to changing rates

If the thought of navigating a changing market seems complicated or daunting, you don’t have to go it alone. A number of investing products aim to help mitigate the impact of rising rates, including:

Real return funds: Real return funds try to provide inflation protection by investing in debt securities such as U.S. TIPS and floating-rate loans, as well as commodities and real estate–related investments. The types of bond investments often found in these funds may be less sensitive to rate changes than typical bonds.

TIPS or TIPS funds: Treasury inflation-protected securities (TIPS) are adjusted semiannually to reflect changes in the U.S. government's consumer price index (CPI),3 a well-known measure of inflation. TIPS are tied to CPI in the hope that as the broad price levels in the U.S. economy rise, TIPS coupon payments will also go up. That potential flexibility could help mitigate the price loss of a rate increase.

Floating rate loans: Floating rate loan funds invest in non-investment-grade bank loans whose coupons "float" at a spread above a reference rate of interest, and thus automatically adjust at periodic intervals as interest rates change.

Of course, there is no free lunch in investing, and each of these comes with trade-offs.

Choose your own mix of strategies

You don't have to choose just one approach. Just as it makes sense to diversify your bond holdings, it may make sense to combine several strategies.

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ETFs may trade at a discount to their NAV and are subject to the market fluctuations of their underlying investments.
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 and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible. Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in the fund.
Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. If sold prior to maturity, CDs may be sold on the secondary market subject to market conditions.
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REITs are affected by changes in real estate values or economic conditions, which can have a positive or negative effect on issuers in the real estate industry. Commodity-linked investments may be affected by overall commodities market movements and other factors that affect the value of a particular industry or commodity.
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The consumer price index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living.
Increases in real interest rates can cause the price of inflation-protected debt securities to decrease.
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1. Fund flow data for mutual funds from January 1, 2008, to December 31, 2012. Source: Strategic Insight Simfund/FI Desktop.
2. Compares the cumulative returns of high-yield bonds, represented by the Bank of America Merrill Lynch BB U.S. High Yield Constrained Index, and Treasuries, represented by Barclays Capital U.S. 3-5 Year Government Bond Index from 5/28/1999 to 6/30/2000. Bank of America Merrill Lynch BB U.S. High Yield Constrained Index is a modified market-capitalization-weighted index of U.S. dollar–denominated, below-investment-grade corporate debt rated BB and publicly issued in the U.S. domestic market. Qualifying securities must have a below-investment-grade BB rating (based on an average of Moody's, S&P, and Fitch) and an investment-grade-rated country of risk. In addition, qualifying securities must have at least one year remaining to final maturity, a fixed coupon schedule, and at least $100 million in outstanding face value. Defaulted securities are excluded. The index contains all securities of the BofA Merrill Lynch BB U.S. High Yield Index, but caps issuer exposure at 2%.
3. The inflation measure used by TIPS is formally known as the U.S. City Average All Items Consumer Price Index for All Urban Consumers (commonly known as the CPI).
Barclays Capital U.S. 3-5 Year Government Bond Index is a market value–weighted index of U.S. government fixed-rate debt issues with maturities between three and five years.
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.
Barclays Capital Investment Grade Corporate Bond Index is an unmanaged market value–weighted index of investment-grade corporate fixed-rate debt issues with maturities of one year or more.
Barclays Capital U.S. 3 Month Treasury Bellwether Index is a market value–weighted index of investment-grade fixed-rate public obligations of the U.S. Treasury with maturities of three months, excluding zero coupon strips.
The S&P 500 Index is a market capitalization–weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
Lower-quality or high-yield securities carry greater risk than investment-grade securities.
Equity investments involve more risk because their value will fluctuate according to their performance.
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