Considering Bonds? Keep an Eye on Interest Rates

If you’re weighing the pros and cons of bonds and other fixed-income investments, here are a few things to keep in mind:

Historical performance.

Under normal economic conditions, stocks tend to outperform bonds over long periods of time. This makes them an attractive option for risk-tolerant investors who are comfortable with the market’s ups and downs.

Yet, in periods of severe economic volatility, bonds, which offer fixed interest rates, can yield higher returns than stocks. In fact, until the stock market began to rally in the second half of 2009, the previous decade generally proved more favorable to bonds than stocks. Barring a default or other unusual event, bond investors receive their principal plus the assigned interest at the time of maturation.

Interest rates and prices have an inverse relationship.

Bond prices are affected by the direction of interest rates. Usually, when interest rates decline, bonds increase in price, and when interest rates rise, bond prices fall. Returns for bondholders typically rise in an environment where interest rates are declining, a trend that has worked to the benefit of bond investors in the past decade.

Today’s low interest rate environment.

The greater risk in the current environment is that interest rates will rise, depressing values of existing bonds. If that occurs, it could have a detrimental impact on your bond portfolio. One way to measure interest rate risk in a bond mutual fund is to look at the fund’s duration. The longer the duration, the more it is affected by changes in interest rates. That can work to your advantage in a declining interest rate environment, but will have a negative impact on your returns if rates move higher.

Historically, interest rates have tended to move higher in periods of an economic recovery. This is important to bear in mind as you consider putting your money in bonds. If the economy continues to build steam, you may need to temper your expectations about future returns on your fixed-income portfolio.

For help identifying what portion of your portfolio to invest in fixed-income and equity investments based on your goals and risk tolerance, consult your financial advisor.