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Fluctuations in interest rates can send ripple effects throughout the economy. Although the latest interest rate hikes are meant to help curb inflation, it is possible that these effects will have an impact on stocks, bonds and other investments.
How To Invest In Bonds With Rising Interest Rates
The Federal Reserve (Fed) has a threefold mandate: to promote maximum employment, stable prices, and moderate long-term interest rates. One way they do this is by adjusting short-term interest rates.
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A review of the Fed’s past actions shows how these scenarios play out. For example, before and during the financial crisis in 2007 and 2008, the Fed cut rates sharply to help jumpstart a sagging economy. Eight years later, rates were still close to zero. As the economy strengthened, the Fed raised interest rates nine times between 2015 and 2018.
Most recently, the Fed cut interest rates three times in 2019 as the economy showed signs of slowing, and twice in 2020 — again to near zero — to curb the economic effects of the coronavirus pandemic.
Current high inflation numbers have prompted the Fed to raise interest rates for the first time since 2018, with additional hikes planned through 2023.
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Given the recent volatility, it’s important to understand how changes in interest rates can affect the components of your investment portfolio.
Interest rates and bonds have an inverse relationship: when interest rates rise, bond prices fall and vice versa. Newly issued bonds will have higher coupons after rates rise, making low-coupon bonds issued in a low-rate environment worth less.
Unlike bonds, changes in interest rates do not directly affect the stock market. However, Fed actions can have trickle-down effects that, in some cases, affect stock prices.
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When the Fed raises interest rates, banks raise their rates on consumer and business loans. In theory, this means less money is available for consumer spending. Also, rising business loan rates can sometimes cause companies to hold back on expansion and hiring. Reduced consumer and business spending can reduce the value of a company’s stock.
However, there is no guarantee that a rate hike will negatively impact stocks. Generally, interest rates rise during periods of economic strength. In this view, rising rates often coincide with a bull market. With a balance of stocks and bonds, your portfolio can be better positioned to maintain more stability even as interest rates rise.
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Understanding The Rise In Long Term Rates
Because interest rate fluctuations can affect investments in different ways, there is no one action you should take when they change.
Stay focused on your financial goals, stick to your plan, and work with your financial professional to build a portfolio that’s diversified enough to help weather any short-term effects of rate changes.
Your investment strategy reflects your goals, risk tolerance and time horizon. Learn how our approach to investment management can help you achieve your vision of success.
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1 “Current Federal Reserve Interest Rates and Why They Change,” The Balance. 2 “How do interest rates affect the stock market?” Investment.
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Equal housing lenders. Deposit products offered by US Bank National Association. Member FDIC. Credit products are offered by the US Bank National Association and are subject to general credit approval. High yield bonds are debt securities, also known as junk bonds, issued by corporations. They may offer higher yields than investment-grade bonds, but they are also riskier investments.
Rising Interest Rate
High-yield bonds (also called junk bonds) are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds. High-yield bonds are more likely to default, so they pay a higher yield than investment-grade bonds to compensate investors.
High-yield debt issuers tend to be start-up companies or capital-intensive firms with high debt ratios. However, some high-yield bonds are fallen angels, which are bonds that lose their good credit rating.
A high-yield bond, or junk bond, is a corporate bond that represents debt issued by a firm with a promise to pay interest and return principal at maturity. Junk bonds are issued by companies with poor credit quality.
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Bonds are characterized by their credit quality and fall into one of two bond categories: investment grade and non-investment grade. Non-investment grade bonds, or high yield bonds, have lower credit ratings from major credit agencies.
A bond is considered non-investment grade if it has a rating below BB+ by Standard & Poor’s and Fitch, or Ba1 or below by Moody’s. Bonds with ratings above these levels are considered investment grade. Credit ratings can be as low as D (deficient), and most bonds rated C or lower carry a high risk of default.
High-yield bonds provide higher yields than investment-grade bonds if they do not default. Typically, the highest risk bonds also have the highest yields. Modern portfolio theory states that investors should be compensated for higher risk with higher expected returns.
How Rising Interest Rates Affect Bonds
Although high yield bonds offer higher earning potential compared to investment grade bonds, they also carry several risks such as default risk, high volatility, interest rate risk and liquidity risk.
Default itself is the most important risk for high-yield bond investors. Diversification is the main way to deal with default risk, but this limits strategies and increases fees for investors.
With investment grade bonds, you can buy bonds issued by individual companies or governments and hold them directly. When you hold individual bonds, you can create bonds to reduce interest rate risk. Investors can often avoid the fees associated with funds by holding individual bonds. However, the possibility of default makes individual bonds riskier than investing in bond funds.
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Retail investors may want to avoid buying individual high-yield bonds directly because of the high risk of default. High-yield bond exchange-traded funds (ETFs) and mutual funds are generally better choices for retail investors interested in this asset class because their diversification helps reduce risk.
Historically, high-yield bond prices have been significantly more volatile than their investment-grade counterparts. The volatility of the high-yield bond market is similar to the volatility of the stock market, unlike the investment-grade bond market, which has much lower volatility.
All bonds are exposed to interest rate risk. This is the risk that market interest rates will rise and cause bond prices to fall. The price of the bond moves in the opposite direction to the price of market interest rates.
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The longer the duration of the bond, the higher the interest rate risk because interest rates have more time to change.
Liquid assets are those that you can easily sell for cash. When bonds are traded frequently, they have high liquidity. Liquidity risk is the risk that you will not be able to sell an asset at a time and for a price that reflects the bond’s true value.
High yield bonds generally have higher liquidity risk than investment grade bonds. Even high-yield bond mutual funds and exchange-traded funds (ETFs) carry liquidity risk.
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You can generally classify bonds into investment grade and non-investment grade. Bonds are rated by three major rating agencies: Moody’s, Standard & Poor’s and Fitch.
When a bond is rated Baa3 or higher by Moody’s or BBB—or higher by Standard & Poor’s or Fitch—it is considered investment grade. Bonds rated Ba1 or lower by Moody’s or BB+ or lower by Standard & Poor’s or Fitch are considered non-investment grade.
With the latter strategy, you buy shares of a fund that is managed by a fund manager, who chooses which bonds to invest in.
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When researching your high-yield bond options, you can read primary documents like the bond’s prospectus, which provides information about the financial health of the company issuing the bond. It also includes the company’s plans for using the proceeds of the bond, along with the terms of the bond and the risks involved.
When interest rates rise, the market value of high-yield bonds can fall because investors can get higher returns with new bonds.
However, rising interest rates can also help high-yield bonds because interest rates rise when the economy expands, so corporations that issue bonds can benefit from increased costs. This means that these bonds will have a lower risk of default.
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A non-investment grade bond is a bond that pays a higher yield but also carries more risk and a lower credit rating than an investment grade bond. Non-investment grade bonds are also called high yield bonds or junk bonds.
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