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Rising Interest Rate Guidance

November 07, 2018

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Rates are Rising

Interest rates have been on the rise, and for good reasons. The Fed has been slowly raising short-term rates for more than two years as it seeks to return interest rates closer to normal levels and stimulus provided by low rates is no longer needed. Long-term interest rates have also increased due to higher economic growth, modestly higher inflation and expectations of further Fed rate hikes. Our view is that as long as inflation remains near or above 2%, the Fed can continue to slowly hike short-term rates without cutting off solid economic growth.

When Rates Rise, Bond Prices Drop

Because bond prices generally move in the opposite direction from interest rates, rising rates have lowered prices of bonds in portfolios, affecting short-, intermediate- and long-term bonds, bond funds and ETFs, as well as unit investment trusts (UITs) that hold bonds. Additionally, the sensitivity of bond prices to interest rates depends on maturity, with short-term bonds less impacted than long-term bonds. In this case lower bond prices are primarily the result of higher rates, so we don't see cause for concern. And remember that interest paid on bonds is based on par value - not market value - so income should not be affected. In fact, income should increase over time as bonds mature and the cash is reinvested at higher market rates.

What Higher Rates Mean

Rising rates could impact bond returns, particularly longer maturities. That said, we continue to expect interest rate increases to be gradual over time, and bonds still play a role by providing diversification and income. Long-term bonds also have a place in fixed-income portfolios by paying higher rates and steadier income over time. When rates are rising and the economy is strong, stocks have performed well. But rising rates may increase volatility.

What Should Investors Do?

Bonds can provide diversification, income and stability, which continue to make them an important part of a well-diversified portfolio. You can’t predict interest rates, but you can prepare your portfolio. Consider the following:

  • Review your portfolio. Stocks have performed well over the past few years, so they may represent a larger portion of your portfolio that you intend. You may need to rebalance to an appropriate mix of stocks and bonds based on your financial goals and comfort with risk.
  • Diversify across maturities, sectors and issues. During your portfolio review, consider adjusting your bond ladder to the recommended ranges if needed. You can invest at current interest rates as short-term bonds mature while earning higher income from intermediate- and long-term bonds. Many intermediate bond funds and ETFs own a portfolio of bonds of a variety of maturities and sectors, which means they are already diversified and laddered.
  • Avoid emotional investing. When bonds drop in price, they will move closer to par value as they near maturity, assuming no concern about default. And don’t forget: The income fixed-rate bonds pay won’t change if interest rates go up.

Important Information:

Before investing in bonds, you should understand the risks involved, including credit risk and market risk. Bond investments are also subject to interest rate risk such that when interest rates rise, the prices of bonds can decrease, and the investor can lose principal value if the investment is sold prior to maturity.

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