If you plan to buy a bond, collect the coupon and hold it to maturity, its value is immune from outside economic influences. Bonds typically trade in $1,000 increments. Many types of bonds have minimum increments imposed either by the bond itself or by the dealer selling them. Increments of $10,000 are the norm.
Bonds typically pay interest at set intervals. Bonds with fixed coupons divide the stated coupon into parts defined by their payment schedule, for example, semi-annual pay. Bonds with floating rate coupons have set schedules where the floating rate is calculated shortly before the next payment.
However, if you plan to buy and sell bonds or bond funds before maturity, it’s important to pay close attention to inflation and interest rates.
Now that the Federal Reserve is considering cutting back on its monthly purchases of U.S. bonds to stimulate the economy, what does that mean to current bondholders or investors thinking about buying them? Here are a few scenarios that illustrate how bond markets move.
Bond Markets: On the Horizon
- Interest rates on the rise
- Short-term bonds safer
- High-yield market grows (so does risk)
A natural occurrence of the Fed reducing its bond purchasing plan will be a gradual rise in long-term interest rates. It would be wise, in this instance, to avoid long-term or intermediate fixed-income bonds or bond funds. These lose value as higher-yielding securities flood the market.
Bonds with shorter maturities are better equipped to stave off the effects of rising rates. Short-term bond funds typically invest in bonds that mature in one to three years. The limited amount of time until maturity means that interest rate risk is low compared to intermediate-term bond funds (those that invest in bonds with maturities of three to 10 years) and long-term bond funds (10 years and up).
Still, even the most conservative short-term bonds funds will have a small degree of share price fluctuation. Examples of funds that should hold up in this environment include, Vanguard Short-Term Investment Grade Fund and Pimco Low Duration Fund.
As the economy strengthens, defaults typically decline and yields increase. That means some high-yield bonds could perform well when interest rates rise because their prices are affected much more by credit quality. However, these are riskier and should be approached with caution.
Given the outlook for rising rates and the debt market’s broad exposure to risks, it’s in your best interest to stick to short-term bond positions or equities that pay high dividends.
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