Financial advisors often recommend that investors who want to minimize risk should place a significant amount of their investments in bonds and bond portfolios. The argument has been that bonds, with fixed percentages of returns, provide certainty and predictability. As a result, some people have invested in bonds and bond funds despite the relatively low interest rates associated with them in recent years.
Recently, however, experts and, now, the Financial Industry Regulatory Authority (“FINRA”) have warned that bonds may carry significant risks when, as many economists predict, interest rates begin to rise. The reason is that, as interest rates rise, so will the interest rates payable in connection with future bonds being issued. And, naturally, the market for existing bonds with lower rates will fall.
As noted by FINRA in a recent Investor Alert, this may significantly impact the value of a current bond investment. A major factor in evaluating how much your bond investments will be affected by rising rates is the bond’s “longevity.” In this context, the “longevity” is the remaining life of the bond. The longer the remaining life of the bond, the more its value is likely to drop in response to rising interest rates.
The FINRA Investor Alert explains:
a bond fund with a 10-year duration will decrease in value by 10 percent if interest rates rise 1 percent. In contrast, if a fund’s duration is two years, then a similar 1-percent rise in interest rates will result in only a 2-percent decline in the bond fund’s value.
This is because the values of new, higher-rate bonds are more attractive to investors, decreasing the value of, and ability to find purchasers for, the lower-interest bonds.
Although a Federal Reserve spokesperson recently indicated that interest rates are unlikely to increase until unemployment drops below 6.5%, or inflation rises above 2.5%, the increasing signs of economic recovery suggest that the question with regard to a rise in interest rates is not “if” but “when.” When this happens, investors who thought their portfolios were comprised of conservative, safe bond investments, may suffer significant losses, explained Marc A. Wites of Wites Law Firm
Bonds and bond funds also carry other risks, such as inflation risk, call risk, default risk and other risk factors. FINRA offers a complete discussion of such factors on its website under Smart Bond Investing.
What should an investor do? Contact your investment advisor bond and bond fund investments.