It's a Wild Time for Bonds
What to Watch for as Interest Rates Rise
By Scott D. Hirsch, Esq. / March 1, 2016
It's a new year, and the belief of the Federal Reserve raising interest rates has become a reality. In the waning months of 2015 the specter of Federal Reserve Chair Janet Yellen deciding to raise interest rates, which for years had been historically low, was the talk of all the financial news organizations. Every time there were meetings or whispers that the Fed would raise rates the financial markets would react wildly. Ultimately, as 2015 closed out the Federal Reserve decided to slowly increase rates, as a result of what its governors perceive is a strengthening U.S. economy that has recovered from the financial crises of 2008.
As we enter 2016 the stock market is experiencing extreme turmoil, but the question remains what is happening in the bond markets? Bonds historically have been a more conservative, or safer, alternative to stocks. There are terrific advantages to bonds; the investor just needs to be aware that not all bonds are created equally. Certainly, this is an important discussion to have with your financial adviser. However, with some general knowledge, you will know whether the particular bond that is being recommend is right, or suitable, for you.
It is important for an investor to know that as interest rates change, so do the values of all bonds in the marketplace. As interest rates go up the value of bonds goes down. Generally, as interest rates go down the value of bonds increases. This is the inverse relationship bonds have to interest rates. Interestingly, interest rate fluctuation does not affect all bonds equally. This is a very important reason to understand the quality of the bonds you have purchased for your portfolio. For instance, typically the longer the bond's maturity (date it becomes due), the more it is affected by changes in interest rates. That means that a bond which matures in ten years will lose more value as interest rates rise then a bond that matures in two years.
Investors should also be aware that lower rated bonds that are considered below investment grade, also known as "junk bonds," are susceptible not only to the fluctuations of interest rates but also they are exposed to credit fluctuations. A perfect example of this was the bonds issued by Puerto Rico that defaulted at the end of the year as result of the territory's inability to meet its debt obligations. These particular bonds were risky, yet were marketed attractively due to their higher yield returns. As is typical in this environment, the higher-quality and safer bonds carry with them smaller yields of interest.
Accordingly, in a time of market turmoil and rising interest rates, investors must be mindful of the composition of any bonds they may have purchased in their portfolio. Investors who are seeking conservative and safer investments, which bonds typically offer, should be aware of the credit quality of their bonds, as well as the duration to maturity. Always discuss your investments with a financial adviser and ask questions to educate yourself. When investing in bonds, particularly in this market environment, don't focus only on the yield; look also at the creditworthiness and the duration of the bond. And remember, what is appropriate and suitable for one is not necessarily suitable for all.
Scott D. Hirsch is a shareholder at the law firm of Scarlett & Hirsch PA in Boca Raton. He grew up and currently lives in Parkland with his wife and two kids.
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