Business & Finance Finance

Bond Strategies in a Rising Interest Rate Environment

Copyright (c) 2010 Brian Fricke

It seems to me like we've been getting more and more calls and inquiries about the concern over bonds. People are wondering how they are going to perform when interest rates start to go up.

In general terms, when we put bonds into someone's investment account, we are buying an individual bond, and we intend to hold that bond until it matures or it's called by the issuer. And if we are paying face value for the bond, then we are going to get all of our money back when the bond is called and matured.

While we hold the bond, we get the stated interest rate or the coupon interest rate that the bond is supposed to be paying. The value of the bond itself will vary one month to the next - it moves up when interest rates drop, and loses value when interest rates go up.

This is why some people are expressing concern right now, when most people believe interest rates can't go much lower. Because this means that bond values are likely going to go down.

This isn't a huge concern for us when it comes to most of our clients and accounts, because we intend to hold the bond until it comes due. When we do that, we get all of all our money back. It's similar to buying a CD and holding it to maturity; you get your interest plus your money back.

When it comes to buying bonds, we always advise whenever possible to buy the individual bond rather than a bond mutual fund. The reason for that is the bond mutual fund has no maturity date. So you can't buy a bond fund with the idea that you're going to hold it to maturity because it never matures. That's why owning a bond fund long enough is a guaranteed way to watch your principle erode in value.

So here's a couple of ways to make money with bonds when interest rates go up. When it comes to making money in a rising interest rate environment, we actually want to own bond mutual funds. But not just any bond mutual fund.

There are two different types. The first one is generally referred to as a floating rate note fund. It's a mutual fund that will buy short-term commercial paper, diversified in a fund, with the interest rates usually tied to an index like LIBOR (London Inter Bank Offer Rate) that resets every 90-120 days. So in a rising rate environment, the yield, or interest, on the fund tends to go up as interest rates increase.

The other type of fund is referred to as an inverse fund or a short fund. These are mutual funds that are engineered to short the bond market or go inverse (in the opposite direction of the bond market). So when bonds are losing value, these funds go up in value.

Either of these two strategies will help combat a rising interest rate environment and keep us earning competitive yields or interest.

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