The U.S. Federal Reserve raised its key interest rate target by another quarter of a percentage point today, to a range between two per cent and 2.25 per cent. It’s the eighth increase since late 2015.
The inverse relationship between interest rates and bond prices
So what does this mean for your investments?
“Bond investors who anticipate rate increases over the next year or two or longer would be in a safer spot with shorter-term bonds or bond funds that hold shorter-term bonds,” said Larry Bates, a veteran Bay St. investors and author of Beat the Bank: The Canadian Guide to Simply Successful Investing.
But it’s not all bad news for long-term bond investors.
“It’s sort of this funny contradiction in the bond world,” said Bates. “If you’re a long-term investor in bonds and interest rates go up, the value of your bond portfolio drops. But bit by bit over time, your returns on your bonds increase because as the old bonds in your fund mature, they buy newer bonds at higher yields.”
In other words, the short-term impact is going to be negative, but in the long run the impact of higher interest rates could be “very positive,” Bates said.
And to be clear, if you’re holding bonds to maturity, rising rates don’t mean you’re losing money. You’re simply missing out on the opportunity to hold bonds with higher rates.
The takeaway for small investors?
Do nothing, according to Benjamin Felix, associate portfolio manager at PWL Capital in Ottawa.
No inexperienced retail investor should be picking bonds on their own, Felix said.
“Bonds are relatively hard to understand and relatively difficult to trade,” he said.
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But bonds can help soften the impact of market downturns on your portfolio. When the stock market crashes, bonds have usually done less badly or even well, Felix noted.
The way to go, he said, is bond index funds, which come with lower fees than actively managed bond funds (much like exchange-traded funds that track the stock market have lower costs than mutual funds).
Something like the FTSE TMX Canada Universe Bond Index, which gives you exposure to both short-term and long-term bonds, is probably a sensible option for many people, Felix said.
“But you have to understand that a shorter-term bond fund might never go more than one per cent into negative territory, but a universe bond fund could go down … four or five per cent or more.”
Above all, though, the most important thing is not to change your portfolio because of interest rate forecasts, he said.
“Your savings strategy and your savings rate is far more important than interest rates.”