If you want to stay in the fixed-income market but are afraid that interest rates might rise, you might want to consider a short-term bond fund. You’re still invested in an income fund, but the shorter maturities of the bonds in the fund’s can potentially protect against losses when interest rates rise.
Rates rise – value declines
Why do bond funds lose value when interest rates rise? Suppose a fund holds a $20,000 bond that pays 4 percent interest per year. Then the U.S. Federal Reserve Board (Fed) raises interest rates, and bonds start paying 5 percent interest per year.
When this happens, the market price of the 4 percent bond in the fund will decline, because no one wants to pay $10,000 for a bond with a 4 percent yield when a bond with the same value purchased now is yielding 5 percent.
Protect against rising rates
This is always the case: When interest rates rise, the market prices of existing bonds fall. (The opposite is true when interest rates fall: Bond prices rise.) But, you can help protect your bond fund against a rise in interest rates by switching to a fund that has a portfolio of bonds with shorter maturities – a short-term bond fund. With such a fund, you won’t be locked into a bond that doesn’t mature for years. The fund will contain faster-maturing bonds, which can be replaced as they mature.
Rate sensitivity measured by duration
Your advisor can help you determine how sensitive your current bond fund is to interest rates, but one way to do so yourself is to look at the fund’s average duration. Duration measures the sensitivity of a fixed-income investment’s price to a change in interest rates.
It is expressed as a number of years. In general, the longer the duration, the more a bond’s price will fluctuate when interest rates rise or fall.