Between rising interest rates and the bond price declines of late, this seems like a good time to review some facts about bonds. After all, we all own bonds as part of a solid asset allocation we've developed for our retirement portfolio. Here’s what you should know about bonds:
Rising rates are actually good for your bond portfolio. In fact, you should be jumping up and down for joy if rates rise because newly issued bonds will pay more in interest. The dividends you reinvest will start paying you more immediately, and the newer bonds you buy whenever your older bonds mature will also pay you more, ultimately benefiting you.
And the rate changes ultimately won't matter for a bond investment since you already bought them. Prices jump around, but bonds that don’t default will always snap back to their par value when they mature. Give a bond enough time, and you'll always get back the same value no matter what happens to interest rates. So if the bond was a good purchase for you initially, rate changes won't change the ultimate results you get from the investment.
Individual bonds lose value just like a bond fund would. Many people seem to think that bond funds somehow act differently to rate fluctuations, but the price swings of a bond fund are just the aggregate of all the price changes of every bond the fund owns. When rates change, the price of each individual bond will change as well. Yes, it's true that a manager of a bond fund may sell bonds at a loss to buy another bond, but the fund could simply let bonds mature too. The only difference is that each individual bond slowly loses its duration, meaning that each bond will be less sensitive to interest rate fluctuations as time goes on. But for most investors trying to keep a diversified portfolio for the long run, they need to keep their durations up anyway, which makes their bond portfolio behave exactly as a bond fund.
Your income stream from each individual bond you already own will stay the same after you make the purchase no matter what happens to rates. They don't call bonds fixed income for no reason. Each bond will pay a specific amount of interest at a pre-determined date. No matter what happens to rates and thus the market value of a bond, you'll receive the same amount of income. For those looking for an income stream from a bond, rate changes don't matter in the short term. And as we already stated before, a higher rate is actually a good thing over the long term because you’ll be able to buy a similar bond with higher interest payments when your bonds mature.
While many people are understandably upset about the temporary price declines of their bond portfolio, I’m actually rather excited about the rate hike because bonds are just about guaranteed to earn more going forward because of the rate increase. Those thinking about income for their retirement should be excited too.
David Ning runs MoneyNing, a personal finance site that shares money moves you can make to significantly increase your chances of having a comfortable retirement. He likes to share simple changes that anyone can make, such as picking the best online savings account and figuring out whether a 0 percent balance transfer credit card makes sense.