As media stories report on a potential hike in the federal funds rate by the Federal Reserve, here are three things to keep in mind.
First, while it is generally true that bond prices fall when interest rates rise, a rate change will likely mean different things to different investors. For example, if you invest in individual bonds and hold them to maturity, a rate hike is apt to be a non-event for your portfolio. On the other hand, if you need to sell bonds you purchased at a lower rate before they mature, you must compete with newer bonds carrying higher coupon rates. A rate hike generally depresses the price of older bonds in the secondary market, which would translate into you receiving a lower price for your bond if you need to sell it.
Second, one market event (such as a Fed rate change) should not be the sole driver of your investment decisions. Another major factor to consider is how bond investments fit into your overall investment strategy. A potential interest rate increase is a good opportunity to revisit your investment goals to make sure that your portfolio is diversified and working for you. It’s also a good time to review your asset allocation, a useful tool to manage systematic risk, because different categories of investments respond to changing economic and political conditions in different ways.
Third, understand that interest-rate risk is one of a number of risk factors to consider when you invest in bonds and other fixed-income products such as bond mutual funds or ETFs. For example, duration risk, the name economists give to the risk associated with the sensitivity of a bond’s price to a one percent change in interest rates, is another factor to keep in mind. Also consider how easily you are able to sell your investment during times of volatility. For factors to consider and questions to ask about bond liquidity, read FINRA’s recent Investor Alert.
As FINRA CEO Rick Ketchum recently noted in an article published on The Alert Investor, “it’s important for all of us—whether we plan to retire next year or in 25 years—to understand the risk and rewards of different fixed-income products and investment strategies and how they will respond to changing economic and market conditions.”