Getting your money right: Now that interest rates are higher, should I consider investing in bonds? (2024)

Dear Kristin,

I am a relatively new investor and have, up until now, only invested in stocks. I have been reading more about the bond market and am not sure if this is a good time to start investing in bonds now that interest rates have risen. Can you tell me more about investing in bonds so I can decide if it makes sense for me?

Signed,

Bondy in Baltimore

Dear Bondy,

This is an incredibly timely question and one that I have been answering for many clients recently. Before we get into it though, I need to provide some context about interest rates and how they correspond to bonds.

Over the past 15 years, we have experienced historically low or falling interest rates. For many investors, this is the first time they have experienced a rising rate environment, so it is important to understand how this rise in rates can impact your portfolio in the coming months and years — especially since many of the strategies we have utilized over the past few years, with varying degrees of success, may not be as effective with this recent rise in rates.

When interest rates rise, bond prices go down in value. Most bonds pay a fixed coupon (i.e. interest payment) and if rates go up, the only way a fixed coupon can equate to a higher interest rate is if the investor pays less for the bond. A bond's duration is the measure of its price sensitivity in relation to a change in interest rates. Duration is a function of maturity, so the longer the maturity of a bond is, the longer its duration will be. The price of a longer-maturity bond is therefore more sensitive to a change in rates than that of a shorter maturity bond, assuming all other things are equal.

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With that in mind, let's go back to my earlier point. If rates are going up and bond prices are going down, why would I want you to think about bonds?

Firstly, bonds as a general asset class have a lower risk measure than stocks. Secondly, bonds generally pay you a coupon — monthly or quarterly, depending on the bond — that provides you with income as part of your investment. With interest rates on the rise, bonds will pay higher coupons.

That said, bonds in general can be complicated and are not without risk. You need to consider interest rates and credit risk —how worthy the borrower or issuer is —before jumping in.

If you look at shortening the duration of the bonds you own, it will help to limit the potential damage that can happen if interest rates rise. If you can attempt to remove the interest rate risk by hedging, bonds become much more interesting.

There are investment strategies that concentrate on short duration, while others focus more on the products that hedge the interest rate of bonds, which essentially mitigates the risk and makes the move in rates much less impactful.

An example of an interest rate hedged bond strategy is when you invest in portfolios of investment-grade or high-yield bonds and include a built-in hedge to mitigate the impact of rising Treasury rates. In most cases, these products do their best to eliminate rate risk while short duration strategies only limit your exposure. You can also express this through asset classes such as floating rate investment grade bonds, bank loans and treasury inflation protected securities, or TIPS.

All of this can be expressed via exchange-traded funds, also called ETFs, and mutual funds. When researching which funds work best for you, consider the track record and expense ratios before making a decision. You should also consult with a financial advisor if you have one.

You will want to look for products that use the FTSE Corporate Investment Grade (Treasury Rate-Hedged) Index for investment grade bonds or the FTSE High Yield (Treasury Rate-Hedged) Index for high-yield bonds as a benchmark to help you make the right decision.

You should also consider your equity portfolio when rates are on the rise. Just because interest rates are going up, it doesn't mean you can't still invest and make money in stocks. That said, not all stocks react in the same way in a rising rate environment, so it's important to research this beforehand.

Certain sectors such as financials have been historical over-achievers. Energy and materials have also done well due to the increase in prices (inflation) that comes along with rising interest rates.

Personally, I have been focused on stocks that pay dividends. These types of stocks are generally lower in risk, are historically solid companies with long track records and have cash on hand to sustain market volatility — plus, they pay you dividends.

There are many ETFs and mutual funds that focus on this kind of investing, which has many names, among them equity income or rising dividend funds. There are also ETFs you can buy that are solely focused on rising interest rates and the sectors and stocks that are most correlated with them.

This is a lot to take in as a new investor. My advice is to always do your research, ask questions and hire a financial advisor if this is too overwhelming for you. My other advice is to not become an expert in bond math —it's truly the most boring thing in the world. Good luck!

If you do want to purchase bonds via mutual fund or ETF, consider using a brokerage that doesn't charge commission fees, like Vanguard or Fidelity. Additionally a robo-advisor like Wealthfront or Betterment can construct a custom portfolio for you based on your risk tolerance, and generally they'll include bonds in the mix of assets that they choose for you.

Kristin O'Keeffe Merrick is a Financial Advisor and money expert at her family-run firm, O'Keeffe Financial Partners, located in Fairfield, NJ.

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