This is a question you could soon begin asking as a recent rise in interest rates contributed to price declines in many bond funds. News the Federal Reserve feels comfortable enough with the strength and state of our economy to consider a change in current monetary policy is, without doubt, a positive development. Unfortunately, for some bond investors, good news may be bad news!
Bond prices and yields have an inverse relationship, meaning they move in opposite directions. This means as yields (interest rates) rise, bond prices (values) can fall. Many investors – driven by fear, the need for income, increasing underweight allocations, or other factors – have invested heavily in bonds. Over the past five years, this demand has helped drive bond prices higher, lowering yields and subjecting many investors to the often ignored or forgotten risks associated with these investments, one of which is "interest rate risk".
"Interest rate risk" is a term used to describe how an investment's value will change due to an increase or decrease in interest rates. As a simple example: a bond yielding 4 percent is more valuable to investors if interest rates fall to 2 percent and is less valuable to investors if interest rates rise to 6 percent. This is because their fixed interest income would either be greater than or less than what a new investor would receive purchasing a bond at current rates. Interest rate risk affects all bondholders, but typically bonds with longer maturities and/or lower yields are most impacted.
- Written by Charles Sims Jr.