As most investors are aware interest rates are rising and that often means that an investment in the bond market may experience a decline. For some investors, the initial reaction is that they should sell all, or most, of their bond holdings and invest the funds elsewhere, such as the stock market. However, before an investor pulls the pin on this piece of their portfolio it’s best to understand why it was purchased in the first place.
Before making any changes it’s important to understand why interest rates affect bond prices. When interest rates rise any new bonds are issued at the now higher rates. Because of that, a similar bond that was issued before the change in the interest rate is now less appealing to investors because the rate isn’t as high as the new offering. As such, the price of the old bond tends to move lower. This is a very simplistic view of what’s happening, but the simple thought is that an increase in interest rate makes bond prices go down, and vice versa.
At this point most investors assume that interest rates will continue to rise over the next one or two years. There has already been a notable move higher in rates in the past 12 months and arguably we have much further to go until we see ‘normal’ rates again. Therefore if rates are going up, bonds may go down, so why invest in them at all?
The vast majority of investors who have added bonds to their broader portfolio did so for the sake of diversification. Generally speaking, bonds should react differently than stocks over the long-term and this has certainly been the case over the past few decades. The addition of bonds to a portfolio therefore tends to reduce the overall risk. By doing so, the intent is that a portion of a portfolio is somewhat protected when the stock market decides to enter a notable period of decline.
The reality is that bonds offer excellent diversification in most markets, but not all. Recently some investors have watched their bond investments decline alongside their stocks. This can happen for a variety of reasons, but stocks can react negatively to a rising interest rate environment too, particularly if there is fear that rates moving higher may lead to a recession as corporate debt payments balloon. If a recessionary period begins interest rates will again fall and should make bond prices rise, and the cycle continues.
With a strong belief in mind that interest rates are moving higher investors can proceed in a few ways. For one, an investor may wish to lighten up on their bond positions, but not eliminate them altogether. The proceeds from their bonds could go to the stock market, or, perhaps to some alternative investments that do not necessarily react to changes in the bond or stock market. This type of shift would be considered a tactical decision and may be short-term until things normalize.
Another consideration would be to remain invested exactly as you are and understand that your bonds will continue to act as a safeguard from a sudden drop in the stock market. Note that in a stock market decline it’s important to understand the bonds may also decline in value, but the idea is that they may not decline as much – hence added diversification. This decision would be strategic and would ideally mean that you stay invested as you always have.
Lastly investors must appreciate that bonds will continue to pay a stream of income, regardless of the changes in their price. For many investors this is a critical piece of their investment puzzle and I encourage investors to focus on why they’ve invested in bonds in the first place, rather than focus on the short-term changes in the price.
Finally it’s best to understand personal risk tolerances and investment objectives prior to making any changes. A qualified wealth advisor will be able to design a proper portfolio that offers long-term diversification and an appropriate allocation to various asset classes which can include bonds, stocks, and alternative assets.
This is for information purposes only. It is recommended that individuals consult with their financial advisor before acting on any information contained in this article. The opinions stated are those of the author and not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. Scotia Wealth Management is a division of Scotia Capital Inc., Member Canadian Investor Protection Fund.
Happy investing,
Derek Fuchs, Senior Wealth Advisor