When volatility strikes the stock market, some investors take refuge in bonds. But while bonds are generally less risky than stocks, they, too, have risks.
Perhaps the greatest is the risk that a rise in interest rates will cause the value of your bond investments to decline. Unfortunately, you can’t eliminate interest-rate risk, but you can take steps to protect yourself.
- One such step is investing in bond mutual funds instead of individual bonds. Although a fund’s net asset value (NAV) will drop when interest rates rise, the fund will replace maturing bonds with higher-yielding bonds. So, higher interest rates can actually help you achieve a higher total return from a bond fund in the long run.
- Another step is thinking about when bonds mature. If the bonds in a fund mature when interest rates are rising, the fund will have to purchase new bonds at a higher price. As a result, the fund’s NAV may drop, but because interest rates are rising, the fund’s yield may rise. The opposite is also true. Generally, the longer a fund’s “average maturity,” the greater the NAV change when interest rates move.
- Finally, you may want to consider a bond fund’s duration, which indicates how much a fund’s price will rise or fall for a given change in interest rates. For example, if rates rise by 1 percent, the NAV of a fund with a 10-year duration would drop by about 10 percent; if rates fall by 1 percent, the NAV of the same fund would increase by about 10 percent.