• Longer bonds are more exposed to rate increases, so if that’s a concern, stay shorter.
• As with mutual funds, having to sell, or revalue on a daily basis, is also a way to lock in losses.
The second point deserves a bit more explanation. Consider a 10-year bond, and assume that rates rise and the value of the bond drops from 100 to 98. Mutual funds have to value that bond on a daily basis, and investors in the funds will therefore see the value of their holdings drop by the same 2 percent. Investors who hold the bond directly, however, may not care, as they will continue to collect coupon payments and get a par payment at maturity. As long as they don’t sell, they will not have a capital loss.
So, although bonds are exposed to interest rate risk, it can be managed. Bonds also present some opportunities, as any payments can be reinvested for a higher return as rates rise. For those worried about a capital loss, though, managing the duration of your bonds, or owning them directly, can mitigate that risk. (We actually have a team here at Commonwealth to help investors who wish to directly own bonds.)
Short answer: Rate increases will hit bonds, but the risk can be managed in a couple of ways. If capital loss can be avoided, higher rates will allow higher returns on reinvested funds.
What about other assets?
This category includes real estate investment trusts (REITs), master limited partnerships (MLPs), preferred stock, and other financial assets that people buy primarily for the dividend. These will perform somewhere between stocks and bonds, with the growth exposure—possibly good for REITs and MLPs, not usually so good for preferred stock—offsetting the interest rate risk to a greater or lesser extent. It’s not usually possible to manage duration with these assets, however, so investors have one less tool to defend against rate risk.
Short answer: These assets may well see short-term loss due to rising rates, but for many, growth will offset that loss over the longer term.
Plan ahead
Rising rates, at least at this stage of the cycle, can be risky for parts of your portfolio, but they also have upside effects. A rate increase is something to be cautiously welcomed, as it represents a real recovery for the economy and a more stable foundation for future growth. It will require planning and perhaps some changes to your current holdings, but the risk is definitely manageable while we await the new opportunities.
Brad McMillan is the chief investment officer at Commonwealth Financial Network, the nation’s largest privately held independent broker/dealer-RIA. He is the primary spokesperson for Commonwealth’s investment divisions. This post originally appeared on The Independent Market Observer, a daily blog authored by Brad McMillan.