Most of us have some allocation of our investments in bonds. This could be individual bonds, or bond mutual funds. The purpose of this is to not have all of our eggs in one basket - namely the stock market. Historically, bond market returns are less volatile and uncorrelated to stock market returns. This does not mean that Bond markets never go down, rather to suggest they move in cycles that tend to be different than stock market cycles. So in a broad sense, when the stock market goes down, the strategy seeks the bond portion of our portfolio to counter some of the negative returns from stocks, that could result in more consistent performance for our portfolio if allocated and rebalanced properly. While this sage old strategy may have worked over the years, today's bond investments are challenged by the ultra low interest rate environment that we've had for past few years.
Interest rates matter greatly to bonds - and is a significant risk category to bond investments, known as Interest Rate Risk. Bond prices and interest rates have an "inverse relationship" - meaning, when one goes up the other goes down. Think about it this like a seesaw or teeter totter. On one side sits Bond Price and on the other sits Interest Rates. One cannot go up without the other going down. To illustrate, if interest rates rise by 1%, the price of a 30 year (long term) bond, would fall by approximately 11%. Conversely, if interest rates fall by 1%, bond prices would rise by a similar amount. Yet, today's 30 year treasury rate stands at 3.4% (source: www.treasury.gov) which is nearly at a 30 year low, so how much lower can it go?
One simple way to help minimize this risk is to position your bond investments in shorter term bonds. The same 1% change in interest rates on a 5 year bond only causes an approximate 3.5% change in bond price. The same "seesaw" picture concept can help here.....where a longer (30 year) seesaw swings up and down more wildly than a shorter (5 year) seesaw. The inverse relationship still exists, but just not as great of an impact.
There are many additional methods of managing Interest Rate Risk in our portfolios, but beyond the scope of this short article. The point to take away here is simply this....Interest Rate Risk is a contributor to your portfolio's overall risk score, and should be proactively managed and considered. So if you are a do-it-yourselfer, who is watching this risk area of your portfolio?
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Securities offered through Royal Alliance Associates, Inc., member FINRA/SIPC. Insurance and investment advisory services offered through Focus Financial Network, Inc., a registered investment advisor not affiliated with Royal Alliance Associates, Inc.