With so many investors putting money into bonds as well as bond funds, it makes a bit of sense to understand a couple of straight facts about these types of investments.
For starters, the value of a bond can fluctuate just as a stock price will, but with bonds the relationship is not necessarily with economic data but with interest rates (although many will argue that there is a direct relationship between economic data and interest rates).
Since rates are at a particularly low point in history, the risk that many bonds and bond pools face specifically is that rates will increase.
It seems reasonable to expect such a risk given that rates are so low that the only way they can go is up.
There are several things that income-minded investors can do to protect themselves against the upside risk to interest rates and many of the professional bond managers have already started taking such measures.
The biggest and most obvious is that they have reducing the duration (length of bonds) on their portfolios.
In the past, longer-term bonds might have been held in order to realize greater income, but given the higher sensitivity of these longer-dated bonds to changes in rates, it has made a lot more sense to hold shorter-term bonds.
Knowing what your portfolio's duration is allows you to determine what a corresponding interest rate change will mean to the market value of your portfolio.
Again, the longer the duration, the more of a price change you can expect to experience, rewarding shorter durations with less volatility and potentially punishing longer-term durations with greater value fluctuations.
The easiest way to figure this out as an estimate is to determine what you expect will happen to rates.
Many rate forecasts are available online at various financial websites, including your own' bank's site.
With the estimated change to rates, investors simply multiply that by the average duration.
So, if you expect to see a 2% increase to rates and your portfolio's duration is 5 years, then you could reasonably expect to see a 10% change to the value of your portfolio.
This works both ways (up or down) but given that rates are expected to increase, it makes sense to expect a drop in value rather than an appreciation in value.
Using this tactic can help you measure the true risk associated with you bond holdings, allowing regular investors who have found this asset class so appealing to put dollar figure to the loss in value that they can reasonably expect to realize in a rising-interest rate environment.
For starters, the value of a bond can fluctuate just as a stock price will, but with bonds the relationship is not necessarily with economic data but with interest rates (although many will argue that there is a direct relationship between economic data and interest rates).
Since rates are at a particularly low point in history, the risk that many bonds and bond pools face specifically is that rates will increase.
It seems reasonable to expect such a risk given that rates are so low that the only way they can go is up.
There are several things that income-minded investors can do to protect themselves against the upside risk to interest rates and many of the professional bond managers have already started taking such measures.
The biggest and most obvious is that they have reducing the duration (length of bonds) on their portfolios.
In the past, longer-term bonds might have been held in order to realize greater income, but given the higher sensitivity of these longer-dated bonds to changes in rates, it has made a lot more sense to hold shorter-term bonds.
Knowing what your portfolio's duration is allows you to determine what a corresponding interest rate change will mean to the market value of your portfolio.
Again, the longer the duration, the more of a price change you can expect to experience, rewarding shorter durations with less volatility and potentially punishing longer-term durations with greater value fluctuations.
The easiest way to figure this out as an estimate is to determine what you expect will happen to rates.
Many rate forecasts are available online at various financial websites, including your own' bank's site.
With the estimated change to rates, investors simply multiply that by the average duration.
So, if you expect to see a 2% increase to rates and your portfolio's duration is 5 years, then you could reasonably expect to see a 10% change to the value of your portfolio.
This works both ways (up or down) but given that rates are expected to increase, it makes sense to expect a drop in value rather than an appreciation in value.
Using this tactic can help you measure the true risk associated with you bond holdings, allowing regular investors who have found this asset class so appealing to put dollar figure to the loss in value that they can reasonably expect to realize in a rising-interest rate environment.
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