presented by Ric Edelman – ‘Tips For Investing In Bonds’
Interest rates and bond prices have an inverse relationship. When one rises the other falls. Think of the seesaw. Once goes up and the other side goes down. Normal times, investors debate about whether interest rates will rise or fall, but these days there is no debate as interest rates are near zero.
So most people have concluded that rates are destined to eventually go back up. Of course, no one knows when that might happen. It could take months, and even years, but eventually it’s reasonable to assume that rates will rise. And when that happens bond values will fall. You know why?
Supply And Demand
You can find the simple law of supply and demand. Let’s say the government issues are a 1% bond and you buy it. After that the government raises interest rates to 2% and you decide to sell your bond.
What will an investor rather buy? Your bond at 1% or the new one that pays 2%? Of course, the 2% bond would be the better choice. So in order to find a buyer for your bond you would have to lower your price.
How much lower?
Based on the calculation called duration. You could lose as much of 7% for every one point increase in interest rates. That is for a bond with a seven-year duration. If interest rates go up 3% bonds value could fall by 21%. So you see bonds aren’t quite as safe as you may have thought. Almost all bonds are at credit rating. This rating estimates the safety of the bonds.
Will you get the interest you promised? Will you get your money back at maturity?
The credit rating helps you know how safe your bond is. Naturally investors are willing to pay more for bonds with high ratings and less for bonds with low ratings. But bond ratings can change. Say if a company or state government gets into financial trouble.
If that happens the bonds that 40 issued the bonds you’ve already bought could get downgraded. And if they get downgraded, you could lose 10%, 20% even 30% or more from your bonds value. And of interest rates rise i.e. 3% on the seven-year duration bond – while this is happening your total losses could be 30%, 40%, and even 50%.
I want to warn you about interest-rate risk and credit risk when investing in bonds. Now I’ll show you how you can reduce your exposure to these risks.
Reduce Your Exposure To Risks
#1) Pay attention to the bonds duration.
Duration refers to the average life of the bond that usually shorter than the maturity date. Long-term bonds are more sensitive to rising interest rates than short-term bonds so you can cut your interest rate risk by only owning bonds that have durations or maturities of seven years or less. The shorter the duration, the lower the risk to rising interest rates.
#2) Only buy bonds that are unlikely to experience cuts in their credit rating.
That means you should focus on bonds that are issued and backed by the federal government (FED). Those without are not as immune to credit risk as those issued by good Uncle Sam.
#3) Don’t over weight your portfolio with bonds
Maintain diversification on not just bonds but also stocks, real estate, precious metals, oil and gas assets that are not directly affected by changes in interest rates or credit ratings. Diversification helps one facing the challenges of the financial marketplace in turmoil.
Edelman Financial is one of the largest independent financial planning firms in the U.S. Ric Edelman has been three times ranked the #1 Independent Financial Advisor in the nation by Barron’s. – edelmanfinancial.com
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