Why less can be more when it comes to investing (Part 1 of 2)
Jessie Szymanski continues to explore why interest rates matter in her latest post for The Blog, describing why short term bonds can fare better in higher interest rate environments – and what investors can do about it.
Most of the time, we like to think that more is more. More friends, more vacations to beautiful places, more time in the day. In situations like these, it’s usually better to have more than less.
But sometimes, less is more. In stock investing, a short-term trade can make you money. In the bond world, shorter-term bonds can mean less risk. And these days, with interest rates likely to rise, reducing risk in your bond portfolio may be more important than ever.
Short term bonds can fare better in higher interest rate environments. Why? In general, when interest rates go up across the curve, bond prices go down. But here’s the key—short term bond prices go down less .
Think of it this way. If you own a long term bond, and interest rates rise, if you sell that bond before maturity, you’ll get less than what you paid for it. If you own a short term bond and interest rates rise, the price will not be affected as drastically as with a long term bond because interest rates are less likely to fluctuate drastically in the short term. My colleague Matt Tucker explains this further in a Blog post on duration.
With interest rates on the rise, investors need to consider the impact on their bond portfolio. Bond portfolios that have lots of long-term bonds may be at risk of serious losses. And investors sitting on cash may feel like they have nowhere to go, stuck between getting back into a nasty bond market or a volatile stock market.
Market Realist – The graph above shows how short-term bonds are much less susceptible to changes in interest rates. Note how long-term bonds lost almost 15% of their value when rates almost doubled throughout the summer of 2013. Short-term rates, on the other hand, lost about 3% of their value during the same period. Keep in mind, though, that there’s no free lunch. The yield on short-term bonds is much lower than the yield on longer-term bonds, but they’re also a much safer investment.
Browse this series on Market Realist: