What do rising rates mean for you and your portfolio?
After hitting an all time low, interest rates are finally starting to rise.
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What Every Investor Should Know About Planning And Saving For Retirement
I want to talk about What Rising Interest Rates May Potentially Do For Your Portfolio And For Your Retirement.
As you may know interest rates are starting to creep up here a little bit. I think we hit the bottom of the interest rate cycle last summer, in July 2016, where if we’re looking at the 10 year treasury, the interest rates got down to an all-time low, the lowest they’ve ever been to of 1.37%. As of about a week ago, we’re just a little bit over 2.5% So we’re starting to see a little bit of an interest rates rise.
What you may or may not necessarily realize is what happens to your bonds that are part of your portfolio when we see these rising interest rates. The way I like to think about it is kind of like a mechanical lever. On one side you have interest rates and on the other side you have the principal value of the bonds that are part of your portfolio. There’s an inverse relationship between interest rates and your principal value. So if interest rates go up, your principal value is going to go down, and if interest rates go down, the principal value of your bonds goes up. Of course if you buy a bond and you hold its maturity, you’re going to get back exactly the amount that was promised to you by the issuer of the bond, assuming they make good on their promises, but in the meantime your bond prices are going to fluctuate on your account statements depending on where these interest rates are going.
So I’ll give you a quick example of this. Let’s say today you buy a thousand dollar bond that’s yielding four percent, and let’s say tomorrow interest rates go all the way up to to five percent. Well first of all if that happened you’d be pretty bummed out because you just bought a four percent bond when the new bonds are being issued at five percent. But what if you wanted to sell that bond, could you? Well you can always sell something but you may not always get back out of it what you want or what you think you’re going to get out of it. So in order for you to sell that bond that is in a five percent interest rate environment you’re going to have to actually lower the price or discount the price of that bond to make it equivalent to all the new five percent bonds that are being issued out there.
Of course the opposite is true as well. If you bought a five percent bond today and interest rates go down to four percent tomorrow, you’ll be able to charge a premium for that bond. In other words charge more than what that bond is ultimately going to mature for because you want to make that equivalent to all the new interest rates. That’s basically how interest rates work, so as you think about your portfolio, think about how these potentially rising interest rates might affect some of your assets that you have inside your account.
Now the other thing here is that it also depends very much on the maturity length of the bonds that are in your portfolio. If you also think of this like a mechanical lever, your shorter term bonds, let’s say the ones that are going to mature in less than five years, are going to fluctuate much less for every percentage change in interest rates. But when we go all the way out here to the 30 year bonds, we’re going to see much bigger fluctuations in that. So one of the ways that we can tell how volatile a bond portfolio is going to be, based on moves and interest rates, is something called duration. And what duration means is it’s an effective way to kind of tie in the maturity, date of the bond that you’re looking at along with any coupons that might be paid along the way and kind of create an effective maturity date or duration. And so if we had a duration of five, for example, what that would mean essentially is that if interest rates were to go up by one percent, we would see a five percent decline potentially in the principal value of that bond. On the other hand if we saw a one percent decline in interest rates, we would see a five percent move up in the principal value of your bond. So duration is something very important to look at especially if you’re looking at the portfolio. You might even want to know what the total duration of your entire account. So pay attention to that as well.
The last thing I want to talk about here is an article that I read here recently that actually was part of what prompted me to put this video together. And it was a research report from Wells Fargo. Basically what this talked about was the Barclays US Aggregate Bond Index and essentially what they talked about in this article was that the Barclays Aggregate Bond Index has actually increased the duration of that portfolio by 62% over the last eight years. So from July of 2008 to December 31st of 2016, the average duration has gone up by 62%. Effectively what that’s doing is that’s raising that duration and also raising the risk if interest rates were to go up. And that Barclays Aggregate Bond Index might be something that could even be tied to some of the assets that you have in your portfolio.
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