Ignore the Threat of Rising Interest Rates and Get on with Your Life.
Have you been waiting and watching for the Federal Reserve to raise interest rates each month for the last few years? If so, how many times would you have been right about an increase since December of 2008?
Zero. Yes, it has been over 6 ½ years since the Fed last made a change to its current Federal Funds Rate target of 0% to 0.25%. And how much interest are you earning by sitting on the sidelines in a bank account these days? I think the numbers speak for themselves.
I am not trying to over-simplify a very complex economy and monetary system. However, I think it is wise to consider a relatively simple way to invest in fixed income by using individual bonds. In my opinion, your focus should be on the total return a bond investment can earn, which is made up of the principal and interest – and not focus on something out of your control.
How it works – Let’s say you buy a new issue $10,000 corporate bond that matures in 3 years and assume it pays 2% interest per year until maturity. If interest rates rise by 1% and new 3 year bonds issued by the same corporation now pay 3%, the demand for your bond will likely go down along with the bond’s price and value. But does that mean you actually lost anything? No. Generally, as long as you hold your bond to maturity, you can continue to collect the stated 2% interest and then get your $10,000 of principal back at maturity. Does it matter if your bond value dipped to $9,500 or some other amount at some point if you still get your full principal back? Of course some bonds may be called along the way and others may default, so it is important to evaluate the terms and risks of any bond investment.
So your choices look like this 1) stay in cash and do nothing because you believe ‘bonds can only go down’ 2) wait for interest rates to go up some and then reevaluate or 3) start earning some more money by investing in a series of bonds (ladder) so that each year you earn interest and when the bonds mature you receive your original cash investment. When each bond matures you can reinvest it at higher rates if indeed interest rates have risen.
This is different than purchasing bond mutual funds which have no maturity, and could be up or down in value in the future when you need the money. When comparing individual bonds versus bond funds, individual bonds offer more clarity about the total return you earn than bond mutual funds. Remember, it’s possible to know at the time of purchase the following: how much interest you should receive each year, how much your principal will be worth in the future and when you are due to receive your principal.