How the Feds Rate Increase Impacts Bonds
Prior to a couple of weeks ago, the last time that the Fed raised interest rates was 2006 – now with a mending economy the Fed Committee has increased the federal funds rate to 0. 25%-0. 50%, up from a range of zero – 0. 25%. It is quite likely that the Fed will continue to slowly raise rates over the coming months which will bring a mix of good and bad trends for the investment markets. An important component for investors, with regard to interest rates is the effect rates have on bond holdings.
As seen in the example below, there are two major risks to bonds. 1) Interest Rate Risk – As interest rates climb the value of existing bonds decreases. Also, the longer the maturity the bigger the decline will be. The technical term for maturity is "duration", which is defined as a measure of the sensitivity of the price of a fixed-income (bond) investment to a change in interest rates. 2) Credit Quality – Think of this like a FICO score with a 'AAA' bond rating being an 820 FICO, while a 'B' rating would be a 435 FICO score. Obviously, just as with a high FICO score, the higher the rating the less repayment risk will be. Over the past year, we've been working on lowering the duration of our client's bonds (thereby reducing their risk) while also trying to keep the amount of high-yield (junk) bonds to a reasonable level. These risks apply to ALL bonds!
Here is how it works- In the example below, if you owned a $10,000 bond at a 5. 5% interest rate you would be receiving $550 per year in interest payments. When rates rise and new bonds are issued, for example a $10,000 bond at a 7. 5% interest rate paying $750 per year in interest, the original 5. 5% bond will be less valuable because the new bond is simply paying more.