The economic recovery has been gaining traction as evidenced by improvements in two important areas: job growth and housing. Investors who fled the equity markets in a panic during the 2008-09 financial meltdown are feeling more confident and have driven the major stock indexes to near all-time highs. If things seem to be looking up, why are bond investors so worried?
The prevailing concern expressed by many respected investment experts and fueled by the media, is that with the economy picking up steam and interest rates near historic lows, the Fed may begin to nudge rates up to stave off future inflation and that could spell trouble for bonds. The concern is valid because, while many factors influence the value of a bond portfolio, changes in interest rates are often the primary driver of both bond prices and performance.
Basic bond math dictates that prices move inversely with changes in interest rates. When rates rise, bond prices fall and vice versa. Investors have already gotten a taste of the impact that rising rates have on their bond investments. Interest rates climbed during the second quarter of this year inflicting some damage on virtually all bond fund categories and especially on inflation-protected securities and foreign bonds.
So, just as the steadily declining interest rates over the last 30 years have driven up bond values, future rate increases will likely depress them. This means that investors today face a bond market that presents an increased risk of loss and a decreased opportunity for returns.
This may suggest that investors should steer clear of bonds or at least make dramatic changes to the types of fixed income investments they own. Be aware, however, that predicting interest rate changes and their specific effects is notoriously difficult. Although many in the financial advice business have been predicting rising interest rates and falling bond prices for years, these forecasts have not yet materialized. Before making major changes to a bond portfolio, investors should take into account three important considerations.