How
to Respond to Higher Interest Rates
Ever
since Federal Reserve Chairman Alan Greenspan indicated that short-term interest
rates would rise gradually, Americans have been bracing themselves for a period
of rising interest rates.¹
Although higher rates are a sign of an improving economy, interest-rate hikes are often
used to help counter inflation and an overheated economy. However, the Federal
Reserve generally is cautious and avoids raising rates too high or too fast in
order not to stifle economic growth.
Just as
the Fed must be cautious, so too must bond investors. As interest rates rise,
there are a number of strategies that bond investors can use to help reduce the
effects of, and perhaps benefit from, rising rates.
Generally,
bond prices move in the opposite direction of interest rates. If interest rates
rise, existing bonds lose value because newer bonds offer higher yields.
However, interest-rate fluctuations generally only affect investors who sell
their bonds before they mature.
One
strategy that bond investors can use to help manage the effects of higher
interest rates is a bond ladder.² This involves buying several different bonds
with varying maturities. For example, to set up a five-year bond ladder, an
investor might buy five separate bonds with maturity dates ranging from one to
five years. When the first bond matures in one year, the investor uses the
principal to buy another five-year bond to keep the ladder intact.
Another
strategy that bond investors can implement is to reinvest in bonds. Investors
may consider putting their money back into longer-term bonds that may offer
higher yields.
Rising
interest rates don't have to spell doom for bondholders. By taking action and
reevaluating their plans during times of rate hikes, bond investors can position
themselves for any market climate.
1) USA
Today, June 2, 2004
2) The principal value of bonds may fluctuate due to market conditions. If
redeemed prior to maturity,
bonds may be worth more or less than their original cost.
