Hi there! Today I am having Pat Murphy, the publisher of Feeling Financial. talk about how to keep your investments safe. Pat writes about personal finance with a focus on how our emotions and behavior affect financial outcomes. Let me know if you would like to submit a guest post.
It’s hard to have a conservative mix of investments these days. With
the threat of rising interest rates, even “safe” investments are
starting to look scary.
Over the past few months, I lost some money in an account that I use
for somewhat “safe” money. This is money I may or may not need over
the next few years, so I invested about 70% in bond funds and 30% in
stock funds. I don’t want to lose it all in a stock market crash, but
I’d like it to earn more than I can get at the bank. The account is
still positive over the time period that I’ve used it, but I’m
disappointed about seeing losses.
I suspect that a lot of people are in the same boat: anybody who
depends on bonds for stability might be in for a bumpy ride.
Bonds Losing Money
Bonds are traditionally considered safe, but you wouldn’t know that by
looking at your last quarterly statement. Of course, any investment
can lose money, but aren’t bonds supposed to stabilize a portfolio?
The fact that bonds can lose money is news to a lot of people. The bad
news is that this is probably just the beginning: as interest rates
rise, traditional bond investments are likely to lose money. Interest
rates are extremely low right now, so there’s really nowhere to go
except up. Granted, we’ve all seen this coming for a while, but things
got messy in May when the Fed announced that they might (someday)
allow rates to drift higher.
What’s an Investor to Do?
If these bond losses are a result of rising interest rates, what can
we do? Lighten up on the types of bonds that lose money when rates
head north. In general, safer bonds with a long “duration” tend
to lose value as rates rise.
Now, I should mention that I don’t believe in timing the markets – I’m
certainly not smart enough to pull it off. Who knows if rates will
rise anytime soon? If they did rise, who knows how fast it would
happen, and how much bonds would actually suffer? That said, I think
it’s a decent idea to shift some “safe-ish” money into bonds that are
less likely to get beat up as rates rise (my medium-term money, for
example – I’m not doing much if anything to retirement accounts).
Making a huge change or trying to sidestep a market crash by going to
cash and then jumping back in is not something I’m interested in.
There are a few types of bonds (or bond mutual funds, for us regular
folks) that seem to hold up better as rates rise:
Short-term bonds don’t suffer as much as long-term
bonds because you’ll get your money back more quickly with a
short-term investment. Then, you – or the fund – can reinvest into
newer, higher-paying bonds. However, short term-bonds generally don’t
pay as much as long-term bonds (assuming all else is equal). So you’ll
earn less income from those investments, but the hope is that that
your account value won’t drop as much if rates rise quickly.
Floating-rate bonds have time frames that are even
shorter than short-term bonds. These might consist of variable rate
loans that banks make to companies. As interest rates rise, the
interest rate on the bank loan will change correspondingly, and the
increased income is passed on to investors. Floating-rate bonds
usually have a higher yield than short-term bonds, but they are also
High-yield bonds, also known as “junk bonds,” pay
high rates of interest because they are high-risk loans. These aren’t
necessarily short-term bonds, but they can be insulated from rising
rates in a different way: as the bond issuers get stronger (by
improving profits in an improving economy, let’s say), their bonds get
more attractive and rise in price. This price increase can help offset
what would otherwise be a price decrease due to rising rates.
What’s the Catch?
Of course, you can never get something without giving up something
else. So what are the trade-offs of shifting to shorter term bonds and
higher risk bonds?
First, rates might not rise, or they might not rise quickly enough to
cause problems. In that case, moving to short-term bonds that pay less
means leaving money on the table. Also, floating-rate bonds and
high-yield bonds are riskier (not so much due to interest rate risk,
but because the bond issuers might run into financial trouble and quit
paying bondholders). As a result, these types of investments are more
volatile and can move up and down – most importantly down – similar to
the stock market. If the economic recovery loses steam, safer bonds
might be the place to be.
Finally, there are other types of investments out there. It’s not just
stocks, bonds, and cash. “Alternative” investments could also be
helpful as rates rise (and, correspondingly, as the Fed tries to hold
off inflation). The challenge is how much of each
investment to use. It seems like you have to have at least
something in bonds to keep a balanced portfolio.
Given all of that, I’m just going to make modest shifts in the bond
portion of my account – not dump everything into short-term and
high-yield. Keeping some exposure to plain-vanilla bonds allows the
account to earn interest and stay stable in case rates don’t
rise; beefing up the short-term and high-yield portions should help
the account weather the storm in case rates do rise.
How do you keep your “safe” investments safe?
You can find Pat over at Feeling Financial or on Facebook.