Any type of investment carries certain risks. Investors often consider bonds a safe source of income, but bonds are especially vulnerable to interest rate risk. When interest rates increase, the resale value of existing bonds and the value of bond mutual fund shares decrease. On the other hand, you risk lower returns when you redeem bonds and reinvest after a decline in rates. Diversification and prudent bond-buying strategies help reduce interest rate risk.
Asset allocation, or balancing investments among different types, helps reduce interest rate risk that you may incur by relying only on bonds. For example, stocks often move opposite to bonds and provide better overall returns when interest rates rise. The Financial Industry Regulatory Authority (FINRA) suggests that risk can be reduced by dividing a portfolio into various asset classes, including stocks, bonds and money market instruments or cash. Your age and risk tolerance must be considered when you determine the appropriate percentages for each category.
Limiting Call Risk
Some bonds are “callable” before the maturity date, which means that the issuer can require you to redeem them early, usually when interest rates fall. You will still receive the bond's face value but you'll miss out on the interest that you expected to earn. If you want to reinvest your money, you may need to accept lower market interest rates. FINRA suggests practicing a strong defense: find out whether bonds are callable and what other rules apply before you invest your money.
A “barbell strategy” means purchasing bonds with short and long maturities in approximately equal amounts. This protects against interest rate risk because you’ll generally have some higher-paying bonds in your mix of long- and short-term bonds. If interest rates rise, you can take advantage by selling short-term bonds when they mature and reinvesting in higher yielding bonds. According to Forbes, a combination of short and long-term bond mutual funds also works as a barbell strategy.
A "bond ladder" helps protect against interest rate risk by leveling out the highs and lows of the rate market. Build a ladder by investing a similar amount in bonds maturing at regular intervals. For example, purchase $10,000 in bonds maturing each year over 10 years. If rates rise, this strategy gives you new money to invest at the better rates every year. Similarly, if rates go down, you only need to reinvest a fraction of your money at the lower rate.
Bonds with longer terms and mutual funds that hold these bonds generally expose you to more interest rate risk. Purchasing bonds with a maximum maturity of 10 years limits this risk, according to CNN Money. For example, a portfolio of bonds in the range of one to 10 years still gives you an opportunity to use a barbell or ladder approach, but you avoid the interest rate risk of economic uncertainties 20 to 30 years in the future.
- Financial Industry Regulatory Authority: Managing Investment Risk
- U.S. Securities and Exchange Commission: Bond Funds and Income Funds
- Forbes: How To Get More Diversification With Less Interest Rate Risk
- CNN Money: Should I Buy Short-Term or Long-Term Bonds?
- Financial Industry Regulatory Authority: Interest Rate Risk
- Financial Industry Regulatory Authority: Call Risk
- U.S. Securities and Exchange Commission: Beginners' Guide to Asset Allocation, Diversification and Rebalancing
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