1. Remain diversifed
For many investors there are good reasons to stick with bonds no matter what the interest rate outlook may appear to be.
a) No one really knows where interest rates are going or when.
b) Bonds can help reduce overall volatility in a diversified portfolio.
The prices of many types of bonds have historically moved inversely with stock prices and fluctuated within a narrower range of highs and lows. So while rates are rising, bonds might lag stocks, but it may make sense to accept underperformance from that portion of your portfolio for the benefits of bonds when and if the environment changes and stocks struggle.
What's more, while the price [net asset value (NAV) for funds] of bonds or bond funds may decrease, the bonds should continue to make the same interest payments, assuming they don’t default or get called. And, as the bonds mature or are sold, they can be replaced with higher-yielding bonds, which could create more income. That could limit or decrease any price losses.
If you have a long-range outlook, a solid asset allocation plan, and plan to hold your bonds to maturity, sticking to your current stock and bond mix may be a strategy worth considering.
2. Shorten duration
Let's say you have a nonretirement goal with a shorter investing timeline—like paying a college tuition bill for which you need a lump sum in less than four years—and cannot afford much risk to the value of the principal. Or maybe you are already living on a fixed income, investing in bonds to create income. Or maybe you can't stomach the thought of adding risk to you portfolio.
Choosing high-quality bonds or bond funds with shorter durations (duration measures the sensitivity of bond price to changing interest rates) can help to mitigate the effect of rising rates. These bonds typically pay less than longer-term bonds and riskier bonds—so their low yields may not be right for investors with longer time frames. But these bonds do mature more quickly, allowing you or the fund manager to put that cash into higher-paying bonds sooner, helping to manage one of the challenges of rising rates.
For a lump-sum goal that's two years away, or less, you may want to consider short-term investments such as an FDIC-insured savings account, a short-maturity FDIC-insured certificate of deposit (CD), or a money market mutual fund, whose yield will tend to follow the federal funds rate closely. An exceptionally short-duration bond fund with high-quality holdings is another potential solution.
Or, build a "ladder" of short-term CDs by creating "rungs" of three months, six months, and twelve months, for example. You may have an opportunity to capture higher yields as you roll over the maturing securities. If you will be in the market a little longer, you may want to consider short or ultra-short duration bond funds, or you could build a longer bond ladder.
3. Accept more risk for higher interest potential
If you can tolerate greater credit risk and volatility, consider investment-grade or non-investment-grade corporate bonds. Despite periods of dramatic price changes, over the long term their relatively high income has contributed the most to their historic overall return. (Remember, past performance is no guarantee of future results.) Given the inherent credit risk associated with these types of bonds, it's important to diversify across many different issuers from different industries.
There are many ways to invest in the corporate bond asset class, including through mutual funds, exchange-traded funds (ETFs), or directly, through individual bonds. You can also construct a longer-term bond ladder. Each method of investing has strengths and weaknesses that you should consider carefully before making your choice.
Beyond traditional bonds, there are other income options. Consider real estate investment trusts, or stock/bond hybrids like convertible bonds, preferred shares, and dividend-producing stocks. Each can have unique risks, and aren’t right for everyone, but they may be worth investigating.
4. Look for products that adjust to changing rates
If the thought of navigating a changing market seems complicated or daunting, you don’t have to go it alone. A number of investing products aim to help mitigate the impact of rising rates, including:
Real return funds: Real return funds try to provide inflation protection by investing in debt securities such as U.S. TIPS and floating-rate loans, as well as commodities and real estate–related investments. The types of bond investments often found in these funds may be less sensitive to rate changes than typical bonds.
TIPS or TIPS funds: Treasury inflation-protected securities (TIPS) are adjusted semiannually to reflect changes in the U.S. government's consumer price index (CPI),3 a well-known measure of inflation. TIPS are tied to CPI in the hope that as the broad price levels in the U.S. economy rise, TIPS coupon payments will also go up. That potential flexibility could help mitigate the price loss of a rate increase.
Floating rate loans: Floating rate loan funds invest in non-investment-grade bank loans whose coupons "float" at a spread above a reference rate of interest, and thus automatically adjust at periodic intervals as interest rates change.
Of course, there is no free lunch in investing, and each of these comes with trade-offs.
Choose your own mix of strategies
You don't have to choose just one approach. Just as it makes sense to diversify your bond holdings, it may make sense to combine several strategies.