How to get ready for rising rates
Fixed-income investors need to prepare for the eventual rise in interest rates after a long time near historic lows. Dave Sandstrom and Lisa Lewitzke discuss how in a Money Talk Video. The transcript is below.
Lisa Lewitzke: So we’re at an interesting time for bonds, Dave. We’re at the end of a 30-year secular bull market in bonds. What should we be expecting?
Dave Sandstrom: You’re right, Lisa. We are at a really interesting time. And we’re coming out of a time frame where people have been accustomed to making some pretty substantial yields in their bond portfolios. And where we are right now in the interest rate cycle, in historically low areas, it’s very difficult to just suddenly generate those same types of yields. So what we’re looking at is being in a situation where rates are likely going to rise in the future. So we need to be looking at our bond portfolios and getting them put into a position where they’re going to be well-suited to take on that rising-rate environment.
Lisa: Okay, so you’re talking about interest rate risk. Duration is a tool that we use to kind of manage that risk. Can you expand on that a little?
Dave: Absolutely. Duration is very, very effective for us to understand the sensitivity of our bond values as they relate to changes in interest rates. So what history has shown us is that in a rising-rate environment, we want to make sure that our durations are set in that intermediate bond space of three to five years. And that has proven to give us the best returns and protect us from those increases in rates.
Lisa: Give us an example.
Dave: So, let’s think about it this way. We’re in a low-rate environment. It’s likely that rates are going to rise in the future. Let’s say your duration in your portfolio is three years. For a one percentage point increase in interest rates, you could expect to lose 3% of the value of your bonds.
Now, let’s say you’ve given in to the temptation to reach for yield, and you pushed your duration out to 10 years. That same 1 percentage point increase in interest rates would now cost you 10% of the bond value – so, pretty significant difference there.
Lisa: And that’s your safe money.
Dave: Correct. So you can see why it’s important that we manage that duration into that intermediate bond space.
Lisa: What are we telling people who just aren’t happy with the low yields they’re seeing on bonds right now?
Dave: Really need to practice patience. People need to be more concerned about the return of their money than they are the return on their money.
Lisa: So Dave, with those risks out there, this is probably a good time to remind investors what role bonds really do play in their portfolio.
Dave: You’re absolutely right. And that role is safety. To have a place that you can turn to where you know that those funds are going to be available.
Lisa: So regardless of the interest rate environments, bonds play an important role because it provides that balance that we’re looking for.
Lisa Lewitzke is a registered representative and investment associate at Landaas & Company.
Dave Sandstrom is a vice president and investment advisor at Landaas & Company.
Money Talk Video by Peter May
(initially posted Aug. 1, 2014)