So you have some bonds in your portfolio. They’re highly rated and have been paying you the interest due. Why worry?
The threat from rising inflation, that’s why.
For the last decade, inflation – at 1.5% – has been half of the 3% average over the last century. Why? Once the real estate bubble burst and the economy fell into a “Great Recession” in late 2008, the Federal Reserve lowered interest rates to near zero to encourage companies to invest and create jobs, and to stimulate consumer spending. Bonds weren’t paying much in the way of interest, but most investors and advisors considered them a “safe” place to invest. Since longer-term bonds – those with 10+ years to maturity – typically pay higher interest than shorter-term bonds, many investors favored longer-term bonds in their portfolios.
Now, the economy has recovered, the unemployment rate is near historic lows, consumer spending is strong and inflation has risen to 2.4%. One of the Fed’s mandates is to keep prices stable and inflation in check, ideally at 2%. The Fed is thus poised to raise interest rates to temper growth and keep inflation in check.
As the Fed raises interest rates, bond prices will have to fall so that their yields can rise to meet these new interest rate levels. Longer-term bonds are more sensitive to changes in interest rates. Their prices will fall farther and faster than those of shorter-term bonds with fewer than 10 years to maturity. Investors thus are wise to migrate the fixed income portion of their portfolios to shorter-term bonds as the Fed raises rates, to protect their principal investment. Once interest rates level off at something more like historically normal levels and the Fed is comfortable with the level of inflation, investors can add longer-term bonds back into their investment risk with less worry about losing principal.