How to manage your fixed-income
investments when interest rates rise
April 2015
Begin by taking a thoughtful approach. Consider total return and not just
current yields. Make sure you maintain portfolio-wide diversification.
When market interest rates surged in 2013, many said it
decline that began in 1982. However, those predictions
Historically low rates will
go up — eventually
haven’t panned out, as economic growth disappointed
Since December 2008, the U.S. Federal Reserve has
and rates declined once again in 2014. Nonetheless, the
held its key short-term interest rate, the federal funds
professionals at Merrill Lynch Investment Management &
rate, at 0% to 0.25%, its lowest level ever. As a result,
Guidance foresee a measured return to higher levels.
interest rates on fixed-income securities, from 30-
was the beginning of a reversal in the general interest rate
day U.S. Treasury bills to 10-year Treasury notes and
“We anticipate that rates will follow the path of
economic growth, which we expect to move higher,”
says John Manetta, senior portfolio manager, Investment
Management & Guidance. “Fixed-income investors,
operating from a position of strength after a 30-year-plus
bull market in rates, would be prudent to plan ahead.”
30-year government bonds, sunk to historic lows and
have risen only modestly since. But the Fed’s policy of
Quantitative Easing ended in 2014, and as an improved
economy allows the Fed to raise its short-term rate
target, rates are likely to work their way higher.
Changing interest rates can be a concern to bond investors
because as rates rise, the price of existing bonds declines.
This paper addresses the effect of interest rate increases
So how should you manage your fixed-income investments
on fixed-income investments and suggests how to position
in light of possible rate changes?
your portfolio in light of those changes. Whether you
already own bonds — individually, or through mutual funds
“Fixed-income investors, operating from a position of strength after
a 30-year-plus bull market in rates, would be prudent to plan ahead.”
John Manetta, senior portfolio manager,
Investment Management & Guidance
or exchange-traded funds (ETFs) — or you are getting
ready to purchase them, it’s essential to understand the key
principles that underlie fixed-income investing so you can
react appropriately.
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Bond fundamentals and rising rates
changes than longer-term bonds because holders will
Interest rates drive bond prices
get their money back sooner to reinvest at the new
A basic principle of bond investing is that interest rates
drive prices: when rates rise, bond prices go down. More
interest rate.
• Lower-quality bonds — issued by companies with lower
specifically, as rates go up, the price of existing bonds must
credit ratings — are more exposed to credit risk. Their
fall in order to make their lower interest payments more
price is affected by changing economic conditions as
attractive to potential buyers. If you own those lower-
well as interest rate movements.
yielding/lower-coupon bonds and you try to sell them, you’ll
find they’ve lost some value.
Maturity matters
As noted above, the prices of bonds with more time before
For example, let’s say you purchased a bond for $1,000 at
they are repaid (longer maturities) are more sensitive to
an annual yield of 4% (its coupon rate), but yields on bonds
rising rates because the new, higher rate applies over a
of that maturity and quality have now risen to 5%. When
longer period. Bonds due to mature in only a few months
you try to sell the bond, no one will pay the $1,000 that you
or years are less affected by higher rates.
paid to earn a 4% yield when they can receive a yield that
is 25% higher. To make your bond equally attractive, you
must lower the price.
The “duration” measurement calculated by bond specialists
shows a bond or bond fund’s sensitivity to interest rate
movements in either direction. It provides a rough estimate
While this inverse relationship between interest rates and
at a specific point in time of how a bond or bond fund’s
bond prices is a basic principle of fixed-income investing,
price will change for a one percentage point change in
the effect of changing rates varies according to the type
yields. The higher the average duration, the more the price
of securities involved. For example:
falls when rates rise. Conversely, the lower the duration,
• Bonds that have fewer years before they are repaid
the less a bond is affected by a rate increase.
(shorter maturities) are less affected by interest rate
Bond terminology
Coupon rate
Fixed-income security
The rate of interest to be paid on a bond from the
A type of investment that regularly pays a set amount
time it is issued until its maturity date.
of income. This includes corporate and government
Current yield
The ratio of the annual interest payment to the actual
instruments and certificates of deposit.
market price of a bond, stated as a percentage. As a
Interest rate
bond’s price falls, its yield rises, and vice versa.
The annual rate that is paid for using borrowed money.
Duration
Maturity/maturity date
The average time for the bond to pay out, including all
The date when the principal amount of a bond
the individual interest payments and the payment of
becomes due and payable.
principal at maturity. The duration measure provides
a rough approximation of the percentage change in
the price of a bond or bond fund for a one percentage
point change in yields.
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bonds, Treasury bills and notes, money market
Total return
Return on an investment, including its capital gain or
loss, dividends and/or interest paid.
“A rule of thumb is that for every 1% change in interest
Credit quality also affects risk
rates, a bond gains or loses 1% in value for every year of
While a bond’s ongoing yield and total return are important,
duration,” explains Manetta. So a 1% increase in market
you want to weigh your desire for higher yields against
interest rates would cause a bond with a duration of 5
the relative safety provided by bonds that may have lower
years to fall in value by 5%. Conversely, a 1% decrease in
coupon rates but higher credit quality and lower risk
interest rates would cause the bond’s value to go up by 5%.
of default. Below-investment grade (“junk”) bonds may
That also means that the larger the duration number, the
greater the impact an interest rate move will have on
that bond or bond fund’s price, and therefore the higher
its interest rate risk. For example, says Manetta, “If the
interest rate increases by 1%, a bond with a one-year
pay a higher yield than government bonds, for example,
but you must be willing to accept a higher risk of default
on these bonds.
What this means for your investments
duration would fall in price by 1%, while the price of a
How you manage your fixed-income investments when
bond with a five-year duration would drop by 5%.”
interest rates rise depends in large part on what types
of fixed-income securities you own and why you own them.
Total return is paramount
Interest rates and bond yields are key factors to consider
Diversification is key
when buying and selling fixed-income investments. But
Remember that fixed-income investments are a core
the most important number to watch is your bond or bond
component of a diversified portfolio. Because they respond
fund’s total return.
differently to the market than equities, an allocation
to bonds and bond funds can deliver incremental income
Total return includes what the bond has paid you in
interest over time (its yield) plus any capital gain or loss
while moderating overall portfolio risk.
resulting from a rise or fall in a bond’s price when it is sold.
“If you seek the greatest diversification benefits, U.S.
Essentially, it shows the full amount you will have earned or
Treasury securities are ideal because they truly react
lost on a bond or bond fund when you finally sell it.
differently to the market — with little or even negative
Pay attention to total return
While interest rates can affect bond prices, it’s the amount you make when you eventually sell your securities plus all the interest you
have earned — the total return — that really matters. The explanation and chart below approximates how a 1% rise in market interest
rates could affect the total return for two hypothetical bond investments when they are sold after one year. Keep in mind that the
duration measure is a rough estimate at a specific point in time of how a bond or bond fund’s price will change for a one percentage
point change in yields. Plus, an increase in the interest rate will negatively affect the bond’s price based on its duration, so the result is
a negative number.
How a 1% rise in market interest rates could affect the total return for two bond investments
Duration
(years)
Capital gain or loss
(duration x 1% rate increase)
Coupon
(yield)
Total return
Gain or loss + coupon
BOND A
5
-5%
2%
-3%
BOND B
10
-10%
3%
-7%
Bond A (with a shorter duration) earned 2% in coupon interest,
but lost 5% in value when it was sold a year after the rate increase.
Here’s how that bond’s total return was calculated:
• Loss in value when sold after rate increase =
Duration (in years) X rate increase = 5 x 1% = -5%.
• Total return = Capital gain or loss + amount of coupon interest
received = -5% + 2% = -3%.
Bond B (with a longer duration) earned 3% in interest, but lost
10% in value when it was sold a year later. In this case:
• Loss in value when sold after rate increase =
Duration (in years) X rate increase = 10 x 1% = -10%.
• Total return = Capital gain or loss + amount of coupon interest
received = -10% + 3% = -7%.
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correlation to equities,” says Martin Mauro, fixed-income
more about bond diversification, read our The Vital Role
strategist for BofA Merrill Lynch Global Research. “But they
Bonds Play in a Diversified Portfolio topic paper.
also deliver the lowest yields.” Because their yields are so
low, he says, investors seeking diversification often add
other fixed-income investments to try to boost returns.
“In addition to their potential for higher returns, other
fixed-income investments also may be less sensitive to
changes in the Fed’s policy and rising rates,” says Chris Vale,
senior vice president, products and solutions, Merrill Edge.
That’s why creating a mix of bond maturities and types of
bonds (corporate, municipal and government; domestic and
international) can be a good strategy for reducing portfolio
risk and minimizing the effect of rising rates, he says. For
“You might also consider adding international1 bonds or
bond funds because they won’t react in the same way to
U.S. interest rate changes,” he says.
If you own individual bonds
If you own or plan to purchase individual bonds primarily
to provide a regular stream of income — for example, in
retirement — you still receive your anticipated income
payments plus your principal at maturity, even if interest
rates rise. The loss of value only comes into play if you
don’t hold the bonds to maturity.
Ideas for managing your bond investments when interest rates increase
Here’s a summary of some strategies you can use to manage your bond investments when interest rates rise, with the pros and cons of each.
ACTIONS YOU CAN TAKE
PROS
CONS
Diversify among types of bonds
Mitigates credit and interest rate risk
Transaction costs
Hold to maturity
Receive income plus principal
Missed opportunities to invest at higher rates
Buy short-duration bonds
Potential to avoid losses and achieve higher return
Transaction costs
Pursue laddering strategy
Potential for better risk/return
Transaction costs
PROS
CONS
Diversify among types of funds
Mitigates credit and interest rate risk
Transaction costs
Stay in fund
Professional management seeks to adapt to evolving risks
and opportunities (for actively managed funds); avoid
transaction costs of selling; maintain diversification
Limited by fund guidelines, which may not
allow manager to optimally position fund
Move to lower-duration fund
Potential for better returns
Transaction/sales load costs
Consider loan participation (floating
rate/bank loan) funds (see page 7)
Potential for better returns
Transaction costs; lower credit quality
means more risk
PROS
CONS
Diversify among types of ETFs
Mitigates credit and interest rate risk
Transaction costs
Stay in fund
Maintain diversification; avoid transaction
costs of selling
Limited by need to match index
Move to lower-duration fund
Potential for better returns
Transaction costs; lower income
Consider fixed-maturity ETFs
(see page 7)
Potential for better risk/return by laddering
Transaction costs
IF YOU OWN INDIVIDUAL BONDS
IF YOU OWN MUTUAL FUNDS
IF YOU OWN ETFs
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“But if you stay with your original, lower-yield bonds until
to maturity’ or ‘bond laddering’ strategies using mutual
they mature, you may miss the opportunity to receive
funds like you can with individual bonds,” says Vale.
more income from a higher-yielding bond along the way,”
Even if the fund manager uses a laddering strategy, those
says Mauro. “That’s why weighing the transaction and
transactions are made within the fund. “You won’t get a
opportunity costs for the change is so critical.”
periodic maturity (and return of cash) from the fund to
If your holding period is shorter (and you don’t intend to
reinvest,” he says.
keep your individual bonds to maturity), then interest rate
Owning shares in a passively managed mutual fund that
risk becomes more important, because the bonds you own
tracks a particular bond index can save you money because
when interest rates rise may fall in price when you try to
of its lower expenses. But unlike an actively managed fund
sell them.
that gives the manager some investment flexibility, your
You can mitigate this risk by using a bond laddering strategy
that creates a portfolio of bonds with staggered maturities.
Then as each bond matures, you can reinvest the proceeds
to seek higher yields as rates rise (see page 6).
If you own bond mutual funds
In a rising interest rate environment, owning shares in
an actively managed, fixed-income mutual fund rather
than individual bonds can provide an advantage because
returns are tied to the fortunes of the securities in the
index. That can leave you more vulnerable to the effects
of interest rates.
If you own bond ETFs
Because most ETFs are also passively managed against a
particular index, they don’t give you access to the expertise
of a portfolio manager. When interest rates move, your
fixed-income ETF simply follows the market up and down.
the fund manager monitors interest rates and can make
So if your bond ETF is invested primarily in longer-maturity
appropriate buy and sell decisions on behalf of the
bonds and you want to mitigate the risk of a rate increase,
fund’s shareholders.
you can’t rely on the expertise of a fund manager to
But the fund’s investing guidelines may also limit the types
and maturities of the bonds the manager can purchase.
And that, in turn, can affect the fund manager’s flexibility
because he or she must have cash on hand to deal with
increasing shareholder redemptions. That’s why you need
to understand the fund’s investing guidelines too.
You also have little control over the decisions the fund
manager makes about whether bonds are sold, held to
maturity, or “laddered” and reinvested. “You can’t use ‘hold
make portfolio decisions for you. You’ll need to weigh the
transaction costs and the missed opportunity to invest at
higher rates, and decide whether to sell the fund and look
for another one with shorter maturities.
Strategies for a rising rate environment
Here are three strategies you can use that are designed
to ease the effect of rising rates on the value of bonds
and bond funds in your investment portfolio:
1.Reduce maturities/manage duration.
Individual bondholders and bond fund shareholders
How to check interest rate sensitivity
for the bond mutual funds you own
can lessen the effect of rising rates by reducing the
You can see the effect interest rates may have on
Because the duration of a bond mutual fund or ETF is
your portfolio of bond mutual funds by looking at the
related to the average maturity of the bonds it holds,
fund’s duration (shown in the fund’s prospectus or
that figure can help you evaluate how sensitive a fund
online information). The higher the number, the more
is to rising rates. (Mutual funds and ETFs typically
a rise (or fall) in interest rates impacts the price of the
include this information in their prospectuses, annual
underlying bonds and the mutual fund’s value.
fund reports and online performance information.)
maturities of the bonds and bond funds they own.
5
You can reduce your portfolio’s exposure to interest
Just as with dollar-cost averaging for stocks, bond
rate risk by shifting the mix to bonds and funds with
laddering means more gradual adjustments to your
shorter durations, Mauro says. That would be especially
portfolio, so the effect is less severe as interest
important if your portfolio consists largely of long-term
rates rise. Of course there are still transaction costs
bonds, he notes.
associated with trading individual bonds, and the
2.Balance risk and return with bond laddering
and reinvestment.
Bond laddering may be an effective technique that
minimum investment you need to build a diversified
bond portfolio is much greater than it would be if you
bought shares in a mutual fund or ETF.
individual bond owners can use to help diversify their
For a rising rate environment, Mauro suggests a ladder
exposure to interest rate risk.
composed of bonds that range in maturity from one
Essentially bond laddering involves creating a portfolio
of bonds with staggered maturities. Then as each bond
matures, you can reinvest the proceeds at higher yields
should rates rise.
to ten years: “This way, when your one-year bond
matures and pays its coupons, you would reinvest the
proceeds into the longer end of the ladder — in this
case, a ten-year bond. By reinvesting the proceeds at
the current interest rate, your portfolio’s yields would
A laddered bond portfolio helps take advantage
of rising rates
Creating a “bond ladder” with staggered maturities and
reinvesting the proceeds as each bond matures can help
you moderate the effect of rising interest rates on your
bond portfolio. As shorter-term, lower-yield bonds mature,
the proceeds are reinvested at the “top” of the ladder
where longer maturity bonds could potentially offer higher
yields. This can increase the total return for the portfolio as
interest rates rise. The diagram below illustrates the laddering
concept, using hypothetical bonds with maturities of one,
three and five years and increasing yields.
increase as rates rise, leading to the potential for higher
total returns.”
If your investment horizon is five years or less, you
should consider a five-year ladder. Your decision on
whether to invest in a single five-year bond vs. a bond
ladder depends on how soon you expect interest rates
to rise, Mauro says. His analysis shows that if bond
yields stay the same for a year or more, investors may
be better off with the single security. But if yields
were to rise substantially over a few years — by one
percentage for example — they may be better off using
a laddering approach. “The ladder also has the advantage
of providing more liquidity — the investor would have
the flexibility to redirect the maturing funds to another
3 YR
Lower
Yielding
Bond
5 YR
4 YR
5 YR
REINVEST
5 YR
REINVEST
Higher
Yielding
Bond
purpose,” he explains.
3.Consider securities that can help protect against
3 YR
changing rates.
There are a number of fixed-income securities that can
1 YR
2 YR
2 YR
offer a level of protection against rising rates.
• Securities with short durations, such as 30-day
YEAR 1
YEAR 2
YEAR 4
A bond ladder, depending on the types and amount of securities within the ladder,
may not ensure adequate diversification of your investment portfolio. While
diversification does not ensure a profit or guarantee against loss, a lack of
diversification may result in heightened volatility of the value of your portfolio.
You must perform your own evaluation of whether a bond ladder and the securities
held within it are consistent with your investment objective, risk tolerance, liquidity
needs and financial circumstances.
6
Treasury bills or two-year Treasury notes
But remember, says Mauro, “before reducing portfolio
duration or average maturity, consider the cost of
forfeiting higher yields and weigh this against the loss
of bond value expected with an increase in interest
rates. If you shift to short-term securities, such as
those with maturities of two years or less, you might
worth owning when interest rate risk is a greater
have to sacrifice a significant amount of yield.”
concern than credit risk.
• Loan participation funds
• Fixed-maturity ETFs
These loan-based investments — commonly known
Fixed-maturity ETFs focus on bond investments that
as floating-rate or bank loan funds — tend to have
mature in a particular year. You can use them to build
lower credit quality because they are issued by below-
a laddered portfolio of bond ETFs with staggered
investment grade companies. But they typically have
maturity dates.
less credit risk than high-yield bonds and might be
How Merrill Edge® can help
If you’re making your own investment decisions
For more about the role bonds play in a diversified
You’ll find exclusive online tools and resources at
portfolio, visit merrilledge.com/bonds to read The
merrilledge.com:
Vital Role Bonds Play in a Diversified Portfolio
• The Fixed-Income Screener to search bonds by
topic paper and get the Understanding Types of
coupon rate, type, maturity, duration, yield and price
Bond Risks fact sheet.
(log in required)
As a Merrill Edge client you have access to a variety
• Merrill Edge Select® Funds and Merrill Edge
of products and resources to help you address the
Select® ETFs simplify your investing experience
impact of rising interest rates:
by leveraging a proprietary Merrill Lynch screening
• Fixed-Income Investment Products
process to help you take the guesswork out of
• A wide selection of bond mutual fund and
ETF offerings
• A broad range of fixed-income securities
including U.S. Treasuries, Municipals, Agencies,
Corporations and New Issue Brokered CDs
• Professional management for your fixed-income
portfolio with Merrill Edge Select® Portfolios
To learn more about Merrill Edge Select®
Portfolios, visit the Investing & Trading section
of merrilledge.com.
• Fixed-Income Reports and Commentary
For ongoing insights from the BofA Merrill Lynch
Global Research team, including the “The
Fixed-Income Digest,” log in to your account
at merrilledge.com and visit the Research section.
selecting mutual funds and ETFs.
To learn more, visit the Investing & Trading section
of merrilledge.com and select “Mutual Funds” or
“Exchange Traded Funds.”
If you’re working with a Merrill Edge Financial
Solutions Advisor™
You can get help to determine an investment
strategy suited to your personal financial situation
with suggested next steps. Visit merrilledge.com/
fsalocator to find a Merrill Edge Financial Solutions
Advisor at select financial centers. Or, call us at
888.ML.INVEST (888.654.6837) Monday
through Friday, 8 a.m. to 10 p.m. Eastern.
If you are not a Merrill Edge client, please
visit merrilledge.com or call 888.MER.EDGE
(888.637.3343) to learn more and get started.
7
1
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to the value of other currencies, custody arrangements made for a fund’s foreign holdings, political risks, differences in accounting procedures and the lesser degree of public information
required to be provided by non-U.S. companies.
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individual issuers, possible prepayments, market or economic developments and yield and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices
typically drop, and vice versa.
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and dollar cost averaging do not guarantee a profit nor protect against a loss in declining markets. Since such an investment plan involves continual investment in securities regardless of
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