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Interest rates

Managing Bond Risks When Interest Rates Rise

In response to elevated inflation, the Federal Open Market Committee has begun raising the benchmark federal funds rate to more typical historical levels, after initially lowering it to a rock-bottom range of 0%–0.25% early in the pandemic. At its meeting in March 2022, the Committee increased the funds rate to 0.25%–0.50% and projected six more quarter-point increases in 2022 and three or four more in 2023.1.

Increasing the federal funds rate exerts upward pressure on a broad spectrum of interest rates, including the cost of financing via bond issues. Bonds are a mainstay for investors who wish to generate income or mitigate the effects of stock market volatility, regardless of the rate environment. You may have concerns regarding the impact of rising interest rates on your fixed-income investments and the steps you can take to mitigate the impact on your portfolio.

Rate sensitivity

According to a report published by Forbes in January 2022, as interest rates rise, bond prices tend to fall. This is because the value of the fixed income payments provided by the bond becomes less attractive compared to other investments that may offer higher returns. In a rising rate environment, investors may be reluctant to commit funds for an extended period, so bonds with longer maturity dates are typically more sensitive to rate changes than bonds with shorter maturities. Consequently, holding short- and medium-term bonds is one method to mitigate interest-rate sensitivity in your portfolio. However, Fortune 500 employees and retirees must bear in mind that although these bonds may be less sensitive to rate changes than longer-term bonds, they typically offer a lower yield.

Duration is a more specific measure of interest-rate sensitivity. The duration of a bond is determined by a complex calculation involving the maturity date, the present value of the principal and interest to be received in the future, and other variables. Multiply the duration by the anticipated percentage change in interest rates to estimate the impact of a rate change on bond investments. For instance, if interest rates increase by 1%, a bond or bond fund with a three-year duration could lose about 3% of its value, while one with a seven-year duration could lose about 7%. The duration of your bond investments can be obtained from your investment professional or brokerage firm.

Typically, if two bonds have identical maturities, the bond with the greater yield will have the shorter duration. Due to this, U.S. Treasuries tend to be more sensitive to changes in interest rates than corporate bonds with comparable maturities. Treasury securities, which are backed by the federal government for the timely payment of principal and interest, are viewed as having a reduced level of risk and can therefore offer lower interest rates than corporate bonds. The duration of a five-year Treasury bond is less than five years, reflecting interest payments received prior to maturity. However, the duration of a five-year corporate bond with a higher yield is even shorter.

If the issuer does not default, a bondholder who holds a bond to maturity will receive the face value plus interest. However, pre-maturely redeemed bonds may be worth more or less than their initial value. Therefore, rising interest rates should not impact the return on a bond held to maturity, but they may impact the price of a bond sold on the secondary market before maturity.

Bond ladders

Owning a diversified blend of bond types and maturities is a less risky alternative for employees and retirees of Fortune 500. This can help reduce the portfolio risk associated with fixed-income investments. The construction of a bond ladder, a portfolio of bonds with maturities that are spaced at regular intervals over a certain number of years, is a structured method to implement this risk management strategy. For instance, 20% of the bonds in a five-year ladder may mature each year.

Depending on an investor's time horizon, risk tolerance, and objectives, bond ladders may vary in terms of size and structure, and may include various categories of bonds. As the bonds at the bottom of the ladder mature, the funds are frequently reinvested at the top. By capturing higher yields on new issues, investors may be able to increase their monetary flow. A ladder may also be incorporated into a withdrawal strategy in which the principal returned from maturing bonds is used to generate retirement income.

With rates projected to rise over the next two to three years, it may be prudent to construct a short bond ladder now and a long bond ladder once rates appear to have stabilized. It is essential for employees and retirees of Fortune 500 to remember that the anticipated path of the federal funds rate is merely a projection based on current conditions and may not occur. Possible change in the actual trajectory of interest rates.

Laddering ETFs and UITs
As long as the bonds are held until maturity, constructing a bond ladder provides certainty, but it can be expensive. Individual bonds typically require a face value minimum purchase of at least $5,000, so constructing a diversified bond ladder could require a substantial investment. Diversification is a technique used to reduce investment risk; however, Fortune 500 employees and retirees should be aware that it does not guarantee a profit or prevent investment loss.

Laddering bond exchange-traded funds (ETFs) with defined maturities is an analogous strategy. Typically referred to as target-maturity funds, these ETFs contain a large number of bonds that mature in the same year the ETF liquidates and returns assets to shareholders. Target-maturity ETFs may increase diversification and liquidity, but unlike individual bonds, the income payments and ultimate distribution rate are not completely predictable.

Optionally, investors may acquire unit investment trusts (UITs) with staggered maturity dates. Typically, bond-based UITs hold a diversified portfolio of bonds whose maturity dates coincide with the trust's termination date, after which you may reinvest the proceeds as you see fit. The UIT issuer may provide investors with the option to reinvest the proceeds in a new UIT, which typically incurs an additional sales charge.

Bond funds
Bond funds, which consist primarily of bonds and other debt instruments, are susceptible to the same inflation, interest rate, and credit risks as their underlying bonds. Thus, falling bond prices due to growing interest rates can negatively impact the performance of a bond fund. Because longer-term bonds are typically more sensitive to rising interest rates, funds holding short- or medium-term bonds may be more stable as interest rates rise.

With the exception of target maturity ETFs, bond funds do not have fixed maturity dates because they typically hold bonds with varying maturities and can purchase and sell bonds before they mature. Consider therefore the duration of the fund, which takes into consideration the duration of the underlying bonds. The greater a fund's duration, the greater its sensitivity to variations in interest rates. Typically, duration is included with other details about a bond fund. Although duration is useful as a general guideline, it is most useful when comparing funds with similar underlying bond types.

The sensitivity of a fund to interest rates is only one aspect of its value; fund performance can be influenced by a variety of market and economic dynamics. Moreover, as underlying bonds mature and are replaced by higher-yielding bonds in an environment of rising interest rates, the fund's yield and/or share price may increase over the long term. Even on the short term, the fund's interest payments could mitigate any share price declines.

It is also essential to keep in mind that fund managers may react differently if declining bond prices negatively impact a fund's performance. By reducing interest payments, some may attempt to preserve the fund's asset value at the cost of its yield. Others may prioritize preserving a fund's yield at the expense of its asset value by investing in longer-duration or lower-credit-quality bonds with higher yields but greater risk. Information on a fund's management, objectives, and flexibility in achieving those objectives is detailed in the prospectus and may be accessible online along with other fund-related information.

Depending on market conditions, the yield and principal value of individual bonds, UIT units, mutual funds, and ETF shares fluctuate. When sold, fund shares, UIT units, and pre-maturely redeemed bonds may be worth more or less than their original cost. ETFs typically have lower expense ratios than mutual funds, but you may pay a brokerage commission whenever you buy or sell ETFs; therefore, your overall costs may be higher, particularly if you trade frequently. Depending on supply and demand, ETF shares may trade at a premium or discount to the value of the underlying shares. UITs may be subject to additional hazards, including the possibility of a deterioration in the issuers' financial condition. There may be tax implications associated with the termination of a UIT and the transfer of an investment into a subsequent UIT. We would like to remind Fortune 500 employees and retirees that working with a financial professional does not guarantee improved investment performance.

Conclusion

Interest rates are like the tide of the economy - they can lift all boats, but they can also leave some stranded. When interest rates rise, it's like the tide coming in, lifting some boats to new heights while leaving others stranded on the shore. Just as it's important for boaters to be aware of the tide and adjust their plans accordingly, it's important for investors to be aware of interest rate movements and adjust their investment strategies accordingly. Just like a captain must navigate the changing tide to reach their destination, investors must navigate changing interest rates to reach their financial goals.

Added Fact:
A recent study by the Vanguard Group found that older adults tend to have a higher allocation to bonds in their investment portfolios compared to younger individuals. While bonds can provide stability and income, it's important to be aware of the risks they can pose when interest rates rise. The study suggests that Fortune 500 employees and retirees may consider diversifying their fixed-income investments beyond traditional bonds to include other options, such as bond funds or target-maturity ETFs. These alternatives can offer greater flexibility and potentially mitigate the impact of rising interest rates on their portfolios. By exploring different investment vehicles, Fortune 500 retirees can better manage bond risks and adapt to changing market conditions. (Source: Vanguard Group, "The global case for strategic asset allocation and an examination of home bias," January 2022)

Added Analogy:
Investing in bonds during a period of rising interest rates is like sailing a boat against the current. Just as a sailor needs to adjust their course and be aware of the changing tide, investors must navigate the impact of rising interest rates on their bond investments. As the tide rises, it can lift some boats to new heights while leaving others stranded. Similarly, rising interest rates can affect bonds differently, causing their prices to fluctuate. Just as a skilled sailor adjusts their strategy to harness the power of the current, investors can mitigate the risks of rising rates by diversifying their bond holdings, considering shorter-term bonds, or exploring alternative investment options. By understanding how to navigate the changing tides of interest rates, Fortune 500 retirees can steer their investment portfolios towards smoother waters and strive to achieve their financial goals.

1) Federal Reserve, March 16, 2022

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.


The Retirement Group is not affiliated with nor endorsed by your company. We are an independent financial advisory group that focuses on transition planning and lump sum distribution. Neither The Retirement Group or FSC Securities provide tax or legal advice. Please call our office at 800-900-5867 if you have additional questions or need help in the retirement planning process.

The Retirement Group is a Registered Investment Advisor not affiliated with FSC Securities and may be reached at www.theretirementgroup.com.

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