Last Week’s Question of the Week: What is the website where you can go and look up your own future Social Security benefit?
ANSWER: The Social Security Administration website at ssa.gov.
HOST: Before we get into this week’s main topic, it sounds like you have some simple rules to implement with regards to investing. What are those?
KLAAS FINANCIAL: Yes, from time to time we like to remind listeners about our 7 Simple Rules to Implement When it Comes to Investing:
- Simpler is better. If it sounds too good to be true and is hard to understand.
- Fees matter. Watch your fees!
- Start saving early. Compound interest is powerful
- Seek professional guidance.
- Diversify, diversify… DIVERSIFY.
- Don’t try to time the market.
- Never pass up a corporate retirement plan match opportunity.
HOST: One question many people may wonder about is when they hear about interest rates rising, what effect does that have on bonds in their portfolio?
KLAAS FINANCIAL: Yes, most people have heard that bonds and interest rates have an inverse relationship — when interest rates rise, bond prices decline. This seems like a good time to explain what a bond is, and then how it reacts in the interest rate environment that we are currently in.
What is a bond? When you buy a bond, you are making a loan to an organization such as a corporation or government entity. A bond is basically an IOU given by a borrower (the issuer) to a lender (the investor). If you buy a bond and hold it to maturity, the issuer pays you interest, also known as a coupon, periodically and returns your principal on the maturity date.
The key point to remember is that interest rates and bond prices move in opposite directions. When interest rates rise, prices of traditional bonds fall, and vice versa. So, if you own a bond that is paying a 3% interest rate (in other words, yielding 3%) and rates rise, that 3% yield doesn’t look as attractive. It’s lost some appeal (and value) in the marketplace.
Another important key concept to understand is about duration. Bond duration is a way of measuring how much bond prices are likely to change if and when interest rates move. In more technical terms, bond duration is measurement of interest rate risk. Duration is measured in years. Generally, the higher the duration of a bond or a bond fund — meaning the longer you need to wait for the payment of coupons and return of principal — the more its price will drop as interest rates rise.
HOST: How does this actually work if there is a 1% increase in interest rates?
KLAAS FINANCIAL: As a general rule, for every 1% increase or decrease in interest rates, a bond’s price will change approximately 1% in the opposite direction for every year of duration.
For example, if a bond has a duration of five years and interest rates increase by 1%, the bond’s price will decline by approximately 5%. Conversely, if a bond has a duration of five years and interest rates fall by 1%, the bond’s price will increase by approximately 5%.
HOST: So, it sounds like even bonds can experience some volatility in our portfolios?
KLAAS FINANCIAL: Yes, while bonds do play an important role in balancing portfolios they, too, can lose depending on the environment. But, bonds can provide some valuable advantages. They can dampen the overall volatility of a stock-heavy portfolio because bond prices USUALLY fluctuate less than stocks, and bonds may provide steady interest payments that help support their returns. Including bonds in your investment mix makes sense even when interest rates may be rising. Bonds’ interest component, a key aspect of total return, can help cushion price declines resulting from increasing interest rates.
HOST: I would assume that it is important to be diversified in your bond holdings just like your stock and mutual fund holdings?
KLAAS FINANCIAL: Yes, diversification is as important for your bond portfolio as it is for your stock holdings. Bonds may be diversified in many ways, including sector, duration, country of origin, credit quality, or issuer type.
Historical performance has varied widely across different international bond markets; an investor holding a portfolio diversified beyond just the U.S. could benefit from the positive returns of one or more bonds while another or others are declining.
Additionally, the prices of international bonds do not always move in concert with U.S. rates, another benefit of diversification. Diversification, however, cannot assure a profit or protect against loss in a declining market.
HOST: So what kind of returns can I expect from a bond portfolio?
KLAAS FINANCIAL: Well that depends on your holdings of course, and the duration of the bonds in your portfolio. It is important to remember that the 35-year bull market in long-term bonds (1981-2016) generated abnormal real returns, particularly during the 1980s (6.6%) and 1990s. In 2018, depending on the type of bonds being held and whether or not they were sold and reinvested last year, you may have experienced some negative returns or very little return.
Catch C.J. Klaas and Maleeah Cuevas on Money in Motion every Thursday on Madison's 1310 WIBA from 8:05-8:35am.