What Should You Do With Your Bonds When Interest Rates Rise?

It can be difficult to know what to do with bonds when interest rates start to rise.  When interest rates rise bond prices go down.  This can cause the value of your bonds to plummet.  It can be tough to stay invested in bonds when the prices start to drop and it is especially tough to stay invested in bonds when you are not sure if staying invested is the right strategy.

One thing that can make a big difference in whether you stay invested in bonds is whether you hold actual bonds or you have your money invested in a bond fund.  If you have an actual bond you do not need to worry about the lower prices as much.  As long as you hold the bond to maturity you will get the promised price, unless something extreme – such as the bond issuer going bankrupt happens.  If you own actual bonds the only loss you would have is an opportunity cost.  The opportunity cost would be the difference between the interest rate paid on your bond and the interest you could have earned on a new bond paying higher interest.  Since bond price decrease as interest rates increase you usually won’t make any more money by selling your lower interest bond and investing in a new higher paying bond.  If the market operates efficiently you would only break even.  More likely you would lose a little money because of the transaction costs of selling the old bond and buying the new bond.

If you own a bond fund then you are more exposed to the lower bond prices due to higher interest rates.  This is because the bond fund has a new price every day that is based in part on the value of the bonds it holds.  One strategy if you have a bond fund is to sell as soon as interest rates start to rise.  It can be difficult to get the timing right on this.   I sold my bond fund earlier this year when interest rates were rising and the value of the shares of my bond fund had taken a dive.   As soon as I sold the bond fund interest rates stabilized and the bond fund is still worth about the same as it was when I sold it.  You also have to figure when to get back into the bond fund.  Since you don’t know when interest rates have stopped rising this is also difficult to determine.

Another strategy is to invest your money in a shorter term bond.  This leaves you less exposed to interest rate risk.   You might also consider investing in  a higher yielding bond.  These bonds are commonly known as junk bonds.  This strategy is based on the theory that the rising interest rates reflect an improving economy and thus the junk bonds are not as risky as their interest rates indicate.   Of course, with this strategy there is a risk that the interest rates don’t reflect an improving economy or the improving economy wasn’t enough to help the company that issued your bond and you end up with a bond that is worthless due to the issuer defaulting.

If you do sell your bonds you want to be sure that you are still properly diversified.   Selling all your bonds and investing the money in stocks leaves you exposed to losing a lot of money if the stock market crashes.  Whatever strategy you decide to pursue with your bonds due to rising interest rates, there will be some risk.  Make sure the risk is worth the potential reward.