The Effect of Interest Rates on Bonds


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For the first time in many years the Federal Reserve is looking at raising interest rates.  They have already increased rates by a quarter of a point.  Over the next several years, depending on inflation and the strength of the economy, they may raise rates several more times up into the more normal 3-4% range.  They do this to try to control inflation and also to give themselves a little breathing room should another recession strike.  To use an analogy, they’ve had the accelerator petal stick to the floor for the last several years while we’ve been on this long hill and now that the hill isn’t so steep, need to be able to give it a little more gas should the car start to slow due to another hill.

Rising rates is good for people who have money in bank CDs since they will be able to turn in their CDs and buy new ones paying much better rates.  Maybe they’ll even be able to get four or five percent per year in a few years.  People who are currently invested in bonds in an effort to get a better return than they could from bank CDs, however, may be in for a rude shock as rates start to climb.  As rates climb for bank CDs, new investors in bonds will demand a higher rate before they will commit their money.  This will cause existing bond prices to decline.

You see, for existing bonds, because they pay a fixed amount every six months, investors demanding a better return will mean that the price of bonds must drop.  A bond paying $40 per year will pay 4% when the bond is trading at $1000 per bond, but paying that same $40 per year it will be result in an interest rate of 8% when the price of each bond is $500 for the investor who buys in at that price.  If bank CDs start paying 4%, bond investors will probably demand 8% from the average bond.  This means those holding bonds at $1000 each right now will see the value of their bonds cut in half if rates rise to that level.

Those who have bond mutual funds will see the same thing.  This is because the value of the bonds inside the mutual fund will decline.  Your fund may keep paying out the same amount of interest each year, but you might see negative returns overall for the next few years as the price of the bonds inside the fund drop by 10 or 20% each year as interest rates rise.  So the question is, should bond investors do something to protect their savings?  The answer is maybe no, and maybe yes.  It all depends on why you are holding the bonds and for how long.

To understand why, let’s look at the fundamentals of what a bond is.  A bond is a loan made to a company (or government body).  It has a fixed amount it pays per year, called the coupon, and a fixed maturity date when the loan will be repaid to whomever holds the bond.  When the bond matures, the company will repay the loan amount, which is normally $1000 per bond.  For whatever reason, the price of bonds are quoted in terms of the $1000 maturity price divided by 10, such that a bond selling for 90 would cost $900.  So if you hold the bond to maturity, and the company is able to repay the loan, you should expect to get $1000 per bond regardless of the price of the bond when you buy it, or what the price of the bond does while you hold it.

So if you are holding bonds right now that cost $900 per bond and they decline in price to $500, you can just wait until the bonds mature and you’ll get $1,000 each for them.  In the mean time, you’ll keep collecting whatever interest amount the bond pays.  For this reason, you really don’t need to worry about an increase in interest rates if you are planning to hold bonds to maturity anyway, meaning that  you are happy with the amount of interest that you are collecting and you don’t need to principle you paid in before the bonds are set to mature.

If you need the principle in a few years and the bonds aren’t set to mature for ten years, however, you have reason to worry.  If interest rates climb as they are expected to do, you may only have two-thirds or even half the amount of money you have now if you sell all of your bonds in a few years.  This means you should either sell the longer term bonds you have and buy bonds with a nearer maturity date for money you need in the next few years or just sell your longterm bonds outright and go into cash.  If you can stand a little risk, you could stay in bonds but just buy bonds set to expire before you’ll need the money.  These bonds won’t pay as much as ones that don’t mature for ten years, but at least you’ll be fairly confident that they’ll pay you $1000 per bond before you need the money.  If you have money you absolutely must have a in a few years, you should really go ahead and sell your bonds and put the money in bank CDs.  Given that rates are expected to rise, it may even make sense to put the money into a one-year or six-month CD so that you can switch into one that pays more in a year or so.

Another reason to sell your bonds is if you are holding bonds that are above the maturity payment rate.  For example, maybe you hold a bond that is set to expire in five years that is trading at 120, or $1200 per bond, because it pays a good interest rate so people were willing to pay more than the maturity price to get the interest payments.  If rates go up, the price will drop and it may never again go to $1200 per bond before it expires.  This means you’ll be locking in a 20% loss on the principle.  If the interest you are earning on the bond is high enough that you’ll still make out well even if you lose $200 per bond due to a decline in the price, you may go ahead and hold the position.  If not, it would make sense to sell and start looking for bonds below the $1000 mark.

Now what if you’re in a bond mutual fund?  Well, again it depends on how long you plan to stay in the bond fund.  If the managers tend to hold the bonds until maturity, it will be no different than if you held bonds yourself in your account.  (Note, if the managers don’t do this and you note a lot of churning in the fund because they’re trying to time the bond market, you’re in the wrong fund.)  So as long as you are able to wait long enough for the bonds that the fund holds to expire, it really won’t matter if the price of the bonds declines in the mean time.  If you need the money in the next few years and the average bond in the fund will not expire for ten years, you may want to look at shifting some money into cash or into a shorter term bond fund.  The shorter-term fund will see the bonds in the fund mature and then buy new ones that will probably pay a higher interest rate.

So with bonds the bottom line is that you should look at the interest rate (or really, the yield to maturity, which includes any loss you’ll suffer because a bond is trading above the price that will be paid at maturity)  and determine both if it is worth the risk that the company will not repay the loan and if it is reasonable compared to other places where you could put your money.  If you decide to buy, you should plan to hold the bond to maturity because then the price fluctuations won’t matter.  If the return is not worth the risk, wait until the price is better.  If you need the money soon and can’t wait for the bonds to mature, you need to look at bonds with a shorter life or just keep your money in cash.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

The SmallIvy Book of Investing on Sale this Weekend


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The SmallIvy Book of Investing, Book 1: Investing to Grow Wealthy

The e-book version of the SmallIvy Book of Investing: Book 1, Investing to Grow Wealthy is on sale for $1.99 tonight and through this weekend.  Be sure to pick up a copy.  It goes through all of the information you need to use stock investing and money management to become financially independent.  Please check it out and then let me know what you think!  SI

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How to Get into Investing with $3,000


 

Ask SmallIvy

Unless you own a business, the most likely way that you will become a multimillionaire in your lifetime is to invest a portion of your income into the stock market.  In fact, people who buy $5,000 used cars every five years and invest the money they would have been spending for car payments with new cars in stocks will gain more than a million dollars over their lifetime just from that decision.  Investing allows you to multiply the money you earn, which makes it a lot easier to gain enough money to become financially independent than it would be to simply earn the money through work and save it.  Paying cash and not paying interest for the things you buy also helps because it lets you keep more of the money you make.

To get started in investing, about $3,000 is a reasonable sum.  The easiest way to invest is to put your money into mutual funds.  These invest in a large number of different stocks, can be purchased by setting up an account online and then using a few clicks of a mouse, and have a performance that bests many professional investors.   $3,000 would allow you to buy into several high-quality, low-fee index mutual funds.  Once you take the initial position, you can send in smaller amounts to buy more shares of the fund.  You can even set up auto-draft to send the money from your bank account to the fund automatically each time a paycheck is deposited.

As an example of mutual fund strategies you could use, let’s look at one of the best families of funds, Vanguard .  For $3,000, you can get into the following funds:

Vanguard S&P500 Fund

Vanguard Explorer Fund

Vanguard Mid-Cap Index

Morgan Growth Fund

Vanguard Small-Cap Index

Windsor II Fund

The first fund invests in the stocks contained in the S&P500 Index, which is a group of large, well-known companies.  The second fund invests in small US stocks and generally makes risky, potentially high profit investments.  The third fund, the Mid-Cap Index, buys medium-sized companies contained in an index of medium companies – some of which will be tomorrow’s leaders.  The Morgan Growth Fund is a managed fund that tries to invest in companies the managers believe will grow earnings more rapidly than the average stock.  The Small-Cap Index buys stocks in an index of small companies; a very volatile group but one that has the largest potential for growth.  The last fund, the Windsor II Fund, invests in stocks the managers feel are good bargains relative to expected earnings and other factors.

There are two different types of funds on this list – managed funds and index funds.  The managed funds will have larger fees than the index funds, averaging about 0.40% of assets (or $4 for every $1,000 invested) versus about 0.20% of assets (or $2 for every $1,000 invested) per year for the index funds.  Note that this is low for managed funds, where many funds charge 1% or more, but still costs more than unmanaged index funds because you need to pay a group of managers to select stocks, where an index fund just buys whatever is prescribed by the index it is tracking.

If you decided to go the managed route, you might select the Morgan Growth Fund to start, then save up another $3,000 and buy into the Windsor II Fund.  In doing this, you would be using the two main stock picking strategies – momentum and value.  Momentum investors buy companies that are doing well and going up in price with the expectation that they will continue to do well.  Value investors find companies that have been beaten down and therefore are good bargains compared to that for which other companies are selling.  Over long periods of time in the past, value investing has done better than momentum investing, mainly because less is lost during market downturns, but both strategies have been in the lead during different periods of time.  By buying into both funds, you’ll cover both bases and make sure a portion of your portfolio is getting the best returns possible at any given time.

If you decided to go the index route, you might first invest $3,000 in the Small-Cap Index Fund, then save up another $3,000 and buy into the S&P500 Index Fund.  In this case you’re buying both momentum and value stocks in each fund.  You’re also buying equal positions in large and small companies.  Overlong periods of time, the Small-Cap index will do better than the large stocks because the companies have more room to grow, but it will be a bumpier ride.  Because the large companies have dividends and multiple product lines in multiple countries, they will be hurt less during market downturns.  Over periods of a few years, there will be times when large stocks will do better, and others where small companies will do better.  Once again, if you buy into both you’ll ensure yourself of having money in the best performing sector at any given time.

Once you have made your initial purchases, the two most important things to do are to 1) leave the money alone and never try to trade to beat the market  and 2) be constantly investing more, buying whichever fund you have less of at the time you’re ready to invest. 

You must accept that you will never be able to guess where the markets will go next because all available information is already priced into the price of the stocks.  Most of the big gains made in the markets that result in the high returns compared to bank accounts are made during a period of a few days or weeks that occur randomly over a period of many years.  If you pull your money out thinking that you’ll miss a downturn and then jump back in, you might miss out on a big rally and only make 5% for the year when the mutual fund you were investing in makes 40%.  You’ll also be paying taxes on any gains if you are investing your money outside of a tax-advantaged account such as an IRA.  Not only will you be paying money in taxes, but you’ll miss out on the compounding that the money you pay in taxes would have generated.

You must constantly be buying more because you need to build up a large position to really make the life-changing gains that investing can provide.  Buying in periodically also allows you to get a better price on the funds you buy because you’ll be buying more shares when prices are low than when they are high.  This means that during periods where the fund price remains essentially unchanged you’ll still make money because you’ll have bought shares on dips in price and lowered the average price you paid for the shares.  If you had dropped all of your money into the market right before the 1929 market crash, it would have taken about 15 years for you to get back to even.  If you had investing right along, putting money into the market every few months, you would have made a ton of money during those 15 years despite the crash.

To learn more about investing and how to manage the money you earn to become financially independent, check out the SmallIvy Guide to Investing, Book 1: Investing to Grow Wealthy.  In there I go through a lifelong strategy of money management, plus give all sorts of information on different investment options and the risks involved.  It also explains how individual stock investing can be used as a way to possibly outperform the market averages for those who want to use individual stock investing to add to their mutual fund investments.

Got and investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.