Though the Fed didn’t raise rates this month, Heidi Richardson explains how to potentially prepare your bond portfolio for the rate regime change.
It has been nearly 10 years since the Federal Reserve (the Fed) last raised interest rates, and though the central bank didn’t hike rates this month, higher rates look to be coming.
The exact timing of when isn’t as important as making sure your portfolio is prepared for an impending rate regime change, one where rates are expected to rise gradually and remain low for long.
Market Realist – Get your bond portfolio ready for the impending rate regime change.
The graph above shows the federal funds rate over the last two and a half decades. The funds rate is the mechanism the Fed uses to regulate short-term interest rates in the economy, which in turn cascade across the yield curve.
In the recent meeting, the Fed kept policy rates unchanged, pointing out that the “uncertainty abroad” made it risky to hike rates. However, we’re likely to see a hike by the end of the year.
The possibility of higher rates in the near future directly affects your bond (AGG) (BND) portfolio. Bonds mainly contain interest rate risk and credit risk. Interest rate risk is the risk of higher interest rates, making coupons on current bonds unattractive compared to those on new ones. Credit risk is that of the issuer failing to make a coupon or principal payment on the bond.
Treasuries (TLT) (IEF), for instance, don’t have credit risk, as they’re backed by the full faith and credit of the US government. However, long-dated Treasuries contain interest rate risk. Meanwhile, high-yield bonds (JNK) contain credit risk, and the ones with long maturities contain both interest rate and credit risk. We’ll explain why long-dated Treasuries have higher interest rate risk in the next part.