The Federal Reserve recently raised its target federal funds rate for the first time since March 2000 . This could be just the tip of the iceberg , though, as many experts believe rising inflation and a strengthening economy will spur continued rate hikes in the near future .
This is bad news for bond investors , since bonds lose value as interest rates rise. The reason for this stems from the fact coupon rates for most bonds are fixed when the bonds are issued . So , if rates rise and new bonds with a higher coupon rate become available , investors are willing to pay for existing bonds with lower coupon rates . Less
So what can you do to protect if rates rise? Your fixed income investments Well, here are five ideas to help you and your portfolio to weather the storm.
1. Treasury Inflation Protected Securities ( TIPS )
First issued by the U.S. Treasury in 1997 , TIPS are bonds with part of their value is linked to inflation. As a result , if inflation rises , so will the value of your TIPS . Since interest rates rarely move higher unless accompanied by rising inflation, TIPS are a good hedge against higher rates . Because the federal government gives TIPS, they carry no credit risk and are easy to purchase , either through a broker or directly from the government on
TIPS are not for everyone , though. First, while inflation and interest rates often move in tandem , their correlation is not perfect . This makes it possible rates could rise even without inflation moving higher . Second , TIPS generally yield less than traditional Treasuries . For example , the 10 - year Treasury note recently yielded 4.75 percent , while the corresponding 10-year TIPS yielded only 2.0 percent . And finally , because the principal of TIPS increases with inflation , not the coupon payments , you will not benefit from the inflation component of these bonds until they get mature.
If you sense to you , try to keep them on a tax-sheltered account like a 401 ( k ) or IRA . Decision TIPS Although TIPS are not subject to state or local taxes , you are required to pay not only the interest you receive , but also on inflation annual federal taxes - based main profit , even though you receive no benefit from this profit until your bonds mature.
2. Floating rate loan funds
Floating rate loan funds are mutual funds that invest in adjustable-rate commercial loans . These are a bit like adjustable-rate mortgages , but the loans are issued to large companies who need short-term financing . They are unique in that the interest on these loans , also called " senior secured " or " bank" loans , adjust periodically to mirror changes in market interest rates . If rates rise , so do the coupon payments on these loans . This helps bond investors in two ways: ( 1 ) it gives them more income as interest rates rise and ( 2 ) it keeps the principal of these loans stable , so they do not suffer the same decline that most bond investments affects when rates increase .
Investors should be cautious , though. Most variable rate loans are made to under -investment grade companies . Although there are provisions in these loans to help ease the pain in the event of default , investors are still looking for funds that a broadly diversified portfolio and a good track record for avoiding troubled companies have .
3. Short -term bond funds
Another option for bond investors is to shift from medium and long -term bond funds in short - term bond funds ( those with an average maturity between 1 and 3 years) their business. While the prices of short-term bond funds do fall when interest rates rise , they do not as fast or as far as their longer -term cousins fall . And historically , the decline in value of these short-term bond funds is more than offset by the proceeds , which gradually increase as rates climb.
4. Money market funds
If capital preservation is your concern , money market funds are for you . A money market fund is a special type of mutual fund that invests in very short-term money market instruments . Since these instruments usually maturing within 60 days , they are not affected by changes in market interest rates . As a result , funds that invest in them are able to maintain a stable net asset value , usually $ 1.00 per share , even when interest rates keep climbing .
While money market funds are safe , their yields are so low that they hardly qualify as investments. In fact, the seven-day average yield on money market funds is only 0.70 percent. Since the average management fee for these funds is 0.60 percent , it is not a genius to see that putting your capital in a money market fund is only slightly better than stashing it under your mattress . However , because the interest rates on money market funds track changes in market interest rates with only a short delay , these funds could be so much more than 0.70 percent by the end of the year as the Federal Reserve continues to interest rate increases as expected .
5 . Bond ladders
" Laddering " your bond portfolio simply means buying individual bonds with staggered maturities and hold until they mature them. As you hold these bonds for their full term , you will be able to redeem the nominal value , regardless of their current market value them. This strategy allows you to not only prevent the ravages of higher rates , but you can also use to your advantage to these higher rates issued by reinvesting the proceeds from your maturing bonds in new bonds with a higher coupon rate . Diversify your bond portfolio under 2 years old , 3 year and 5-year Treasuries is a good start to a laddering strategy . If rates rise, you can then broaden the ladder to include longer maturity bonds.
David Twibell is President and Chief Investment Officer of Flagship Capital Management , LLC , an investment consulting firm in Colorado Springs , Colorado . Flagship provides portfolio management services to high - net worth individuals , businesses and non - profit organizations
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