An interesting fact about bonds: when the interest rate rises on newly issued bonds, the old ones you have with a lower interest rate become worth a little less on the resale market. After all, why would someone buy your bond on the resale market when they can easily get a better deal (higher rate of return) elsewhere? That means older bonds with a lower interest rate can only be resold at a discount.
This unfortunate fact is particularly relevant if you own a mutual bond fund or an index bond fund that manages your bonds for you. The value of your mutual fund goes down as interest rates rise. The fund provides you with more diversity, liquidity and a lot of convenience, but that is the price you pay. When interest rates rise, the mutual fund or bond fund will automatically devalue the bonds they have and reflect its overall declining values in your statement. Conversely, should interest rates fall in the future, the bond fund you own with higher-interest-rate bonds suddenly becomes worth much more on the resale market. This issue is called interest rate risk. The concept is the lower the fixed interest rate on a bond until maturity, the higher the interest rate risk (also called market risk) on that bond. The higher the interest rate on a bond until maturity, the lower the interest risk on that bond.
If you buy the bond yourself, you may always keep the bond until the maturity date and not lose any actual money. Although you are not losing money in theory, there will still be lost opportunity costs associated with holding your lower interest rate bonds (e.g., you could have done something more profitable with your funds).
Three Common Investor Solutions to the Problems of Interest Rate Risk:
1. Buy U.S. Treasury Inflation–Protected Securities (TIPS). This type of bond is linked to inflation and the Consumer Price Index. The value of the bond is adjusted upward as inflation rises. The payout can also be adjusted downward in the case of deflation.
2. Buy a bond fund that invests in TIPS.
3. Build a bond ladder. The objective of a bond ladder is to minimize your interest rate risk by reducing your exposure to rising interest rates. A bond ladder example:
Take all or part of your money allocated to bond investing and divide it into four equal piles. Buy short-term bonds at the below intervals:
3 months
6 months
9 months
12 months
As each bond period expires, replace the bond with another bond with a 12-month maturity date. Using this technique, every three months some of your bonds will need to be renewed. This practice will limit your interest rate–risk exposure. A bond ladder, however, does not have the diversity you typically get in a bond fund, which carries its own risks. You can also create a ladder with different maturity dates such as 6 months, 12 months, 18 months and 24 months. Realize that the longer you hold a bond, the longer you tie up the money and the more risk you run because rates may rise and your bonds will decrease in value. You are permitted to cash in a bond fund before its maturity but you may pay a price/fee to do so.
Creating a bond ladder could be a lot of work for you. Luckily, some brokerage firms (like Fidelity, T. Rowe Price, Vanguard, etc.) will handle this for you with no/minimal maintenance fees or charges.
—Lisa Faulkner
