The Fed, Interest Rates and BondsSubmitted by Orange CA Financial Advisor | Sterling Wealth Partners on December 14th, 2016
Since 2009 interest rates (as measured by the Federal Funds Rate) have been near zero, which is well below the historical average rate. As the economy has strengthened the Federal Reserve Bank has increased rates by ¼ %, and has indicated that it may begin to raise rates further. While projections are for a gradual increase, increases in interest rates can have a negative effective on the value of bonds. There is an inverse relationship between interest rates and bond prices. Generally, as interest rates fall, the price or value of bonds rise and as interest rates increase the price or value of bonds declines. This relationship makes sense if you consider the following example: if a person owns a bond that pays 3% but interest rates increase and someone can now buy a bond that pays 4%, the value of the 3% bond is going to be lower if the person needed to sell the bond. Generally, the longer the term or duration of the bond the bigger the increase or decrease in value as rates change. For example, a 1% interest rate increase will potentially cause a 19.2% decrease in the value of the bond. If someone owns the bond, they do have the option of holding until maturity and avoid the price fluctuations as rates change. However, if bonds are owned in a mutual fund, they could be liquidated by the portfolio manager which creates a risk of loss. As we inch nearer to additional rate increases by the Federal Reserve, it is time to take a closer look at the risk associated with the bond or fixed income portion of your portfolio.