Interest rates are rising and bond prices are falling. Here’s what investors can do to prepare

Published Sun, Mar 27 20228:54 AM EDT

Interest rates are rising, and so bond prices are falling. That means it's time for investors to draw up a strategy around the fixed income allocation of their portfolio. On March 16, the Federal Reserve approved its first interest rate hike in more than three years. Central bank members also penciled in six more rate increases for the remainder of the year – a hike for each upcoming meeting. Since then, Fed Chair Jerome Powell said at an economists' conference this past Monday that the central bank could boost rates even more aggressively, if needed, to tamp down inflation. Wall Street has heightened its expectations for a tougher stance from the Fed, with traders anticipating half-point rate hikes at upcoming central bank meetings. The news isn't great for investors who are holding bonds, as yields move inversely to prices. "What we saw was that yields went up, and bond portfolios went down in value," said Jamie Hopkins, managing partner of wealth solutions at Carson Wealth Management Group. When the Federal Reserve raises rates it typically sparks a jump in bond yields. Then, newly issued bonds will have a coupon – an interest payment to investors— that's higher than that of older bonds. In turn, this can lead investors to sell their older bonds to snap up new issues and spur declines in prices. "It's definitely top of mind for a lot of investors, where you're not necessarily going to be made whole if interest rates rise and you sell during this period of interest rate changes," said Christine Benz, director of personal finance at Morningstar. Here's how to prepare your portfolio for changing interest rates. Rethinking bond strategies Investors reassessing their fixed income allocations need to keep a close eye on two factors: duration and credit risk, according to Kathy Jones, chief fixed income strategist at Charles Schwab. Duration is a measure of a bond's sensitivity to interest rates. Several factors go into figuring out duration, including a bond's coupon and its maturity. Long duration bonds tend to have the most sensitivity to interest rates. Meanwhile, credit risk refers to the default risk of a bond issuer. Bond laddering is one way for investors to manage interest rate risk, according to Chip Hughey, managing director of fixed income at Truist Advisory Services. Laddering involves purchasing bonds with staggered maturity dates. The strategy keeps investors from being locked into a single interest rate, and it allows them to reinvest the proceeds of maturing issues into new longer-dated bonds. "Bond laddering is a tried-and-true portfolio structure for a good reason," said Hughey. "It works in a cost-effective manner. When you're in a rising yield environment, in which we find ourselves right now, that is a viable strategy." Jones of Charles Schwab said that she's in favor of keeping duration low as the Fed hikes rates. She also likes a barbell approach. In this fixed income strategy, an investor buys only short-term and longer-dated bonds. "We have some longer-term allocation and some short-term allocation just to take advantage of the fact that every time the Fed tightens like this, you're going to end up with a flatter yield curve," she said. "So a barbell can make sense." Three steps investors can take now The hitch for fixed income investors is that bond laddering and barbells require active management. "I tend not to be a big enthusiast of bond laddering, especially thinking about individual investors," said Morningstar's Benz. "There's the complexity, and it could be hard to get diversified appropriately with laddering." Here are three steps individual investors can take as rates rise. Consider a low-cost actively managed bond fund: Outsource fixed income management to the experts. "You want an active manager who is careful with credit-quality risk and duration risk," said Benz. "My bias is toward being in a low-cost bond fund." Fund shops she highlighted include Fidelity, Baird and Dodge & Cox. Review your asset allocation: Rising bond yields means that bond prices are falling, which can throw off your asset allocation and risk exposure. "Your bond portfolio might fall 6% or 7%, and instead of it bring a 50-50 split between bonds and equities, you might be 75-25," said Hopkins. "Keep an eye on your total allocation as rates move." Rethink how you're using your fixed-income sleeve: Be mindful of your holding period for bonds and your purpose so that you're not selling out of fixed income as prices are declining. This is especially important for retirees. "Not holding bonds for near-term expenditures seems like the right call for this environment," said Benz. "Hence, you're holding cash for two years of expenses or any expenditures I want to have in the next two years."

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Interest rates are rising, and so bond prices are falling. That means it's time for investors to draw up a strategy around the fixed income allocation of their portfolio.