Do you want to stay in the fixed-income market but are afraid that a rise in interest rates might erode bond prices? A short-term bond fund may be a good investment vehicle for you.
When interest rates fall
First, let’s examine how interest rates affect individual bonds. Say interest rates are falling. If you buy a $10,000 bond when interest rates are at 8%, your bond yields 8%, or $800, annually.
Now let’s assume that after you purchase that bond, interest rates fall to 7%. A newly purchased $10,000 bond yields $700 annually. Because your existing bond pays $100 more a year, it is more valuable, and its price will tend to rise.
When interest rates rise
In contrast, when interest rates rise, bond prices fall. If you buy a $10,000 bond at 8%, your bond yields 8%, or $800, annually. Now let’s assume interest rates rise to 9%. A newly purchased $10,000 bond yields $900 annually. Because your existing bond pays $100 less a year, it is less valuable and its price will tend to fall.
The same holds true for bond funds ,which are simply portfolios of individual bonds and behave the same way.
When today’s historically low interest rates begin to rise and bond values fall,
you don’t want to be “locked in” to bonds that don’t mature for years, because they will be worth less than newly purchased bonds.
Consider short-term funds
So, how can you protect your bond fund against a possible rise in rates? You could switch to a portfolio of bonds with shorter maturities – a short-term bond fund. If you purchase faster-maturing bonds, you’ll be able to replace lower-price bonds as they mature. You can do this yourself by purchasing individual bonds, or you can purchase shares of a short-term bond fund. To decide what’s best for you, explore your options with your financial advisor.