Broker Check

Fixed Income: How Rising Rates Kill a Portfolio

| January 28, 2019

Over the years, Cornerstone Financial Services spoke often with clients about the effects of interest rates on traditional fixed income. We’re continuing that practice because everything still holds true in 2019.

In this post – the first of an entire series on fixed income – we’ll examine how rising interest rates affect traditional fixed income strategies.

Rates and Bond Valuations

It’s been widely expected the Federal Reserve would raise interest rates four times in 2019, just as it did in 2018.

But with the Fed being careful about the potential effects of four hikes on the yield curve, it seems we’ll get just two increases in 2019, after 2018 saw the federal funds target rate move from 1.5 to 2.5 percent.

This is important because when interest rates rise, the value of currently held bonds falls. And that means traditional, “safe” fixed income strategies can suffer.

First, some terminology. A bond’s par value is its face value – the amount bondholders are promised from bond issuers once the bond hits its maturity date.

Let’s say you bought a bond with a par value of $100 that issued $1 of interest. A year later, interest rates rise such that new bonds have par values of $100 and pay $1.25 in interest. That means the bond you bought a year prior is worth less because new bonds yielding higher interest are available.

The chart below reflects the weighted par values of common bond indices at the end of 2017 and 2018. As you can see, values decreased across the board in 2018, primarily because of rising interest rates.

That trend will continue in 2019.

Traditional Safety is Gone

The conventional thinking is stocks are volatile and risky, while bonds are conservative and safe. That’s why most people dump stocks for bonds as retirement nears.

But in a rising rate environment, bonds are just as risky as stocks, if not more.

The bond market is certain – when rates rise, bond values decrease. And we know rates are going to rise. In fact, there is still more room to bring rates up before we hit historical averages.

Where to Go?

As retirement nears, people want (and need) to reduce risk and avoid volatility with their money. But if the traditional safety of bonds is no longer available, it begs the question – where do you go?

Well, there are options available.

In future installments of this series, we’ll discuss alternative fixed income strategies, including some that are non-correlated (and even negatively-correlated) to the stock market.

Securities offered and sold through CoreCap Investments, Inc., a registered broker/dealer and member FINRA/SIPC. Advisory services offered through CoreCap Advisors, Inc., a registered investment advisor. Cornerstone Financial Services and CoreCap are separate and unaffiliated entities.