Saturday, August 2, 2003

Personal Finance

Rate rise is bad news for bonds

Amy Higgins

Interest rates are on the rise, and that could mean trouble ahead for bond portfolios.

Investors who have plowed money into bonds thinking that they were safer than stocks might find themselves fighting a losing battle with their portfolios.

"As interest rates rise, with that pocket of your portfolio, you will lose principal value," said Jeannette Jones, president of The Asset Advisory Group in Blue Ash.

Indeed, despite bonds being more stable than stocks in the last few bear-market years, bonds are not bullet-proof.

That's because bond prices drop as interest rates rise.

New bonds get issued at those higher yields, but the rates on your existing bonds usually are fixed. So if you trade them before maturity, you have to sell for less to convince a buyer to accept your lower-interest bonds over a new, higher-interest one.

Yields on the rise

The yield of the 10-year U.S. Treasury bonds bottomed out at 3.11 percent in mid-June and jumped to 4.44 percent this week. Yields on corporate bonds also have risen, as they typically mirror moves in the Treasury market while also being tied to the company's credit quality.

History shows that yields can rise much farther. The 10-year Treasury topped 15 percent briefly in 1981. Yields have stayed under 6 percent mostly since 1998.

Investors holding bonds outright - without intending to trade them before maturity - typically don't need to worry about a loss in principal when interest rates rise.

"If they are in individual bonds, just calm down and just collect the principal payoff at the maturity of the bonds," Jones said.

"The only risk then is in opportunity costs."

But that's not usually the case with bond mutual funds. Some bond funds have lost about 5 percent of their net asset value in just the last two weeks, Jones said.

Don't sell just yet

Bond investors worried about a bursting bubble should first consider the duration of the bonds or bond fund they hold, Jones said.

That's because the longer term issues are more sensitive to the interest rate movements.

Bond funds often have in their name whether they focus on short-, intermediate- or long-term bonds. But fund descriptions and prospectuses go into greater detail about the number of years that means.

An intermediate fund, for example, might focus on bonds with maturities of three to 10 years. Long-term funds primarily hold bonds with durations of more than 10 years.

"If they see that their funds are much longer term, they may want to lower their exposure to that," Jones said. "But I'm not saying panic and sell out of all bonds."

Indeed, Jones still thinks that short-term bonds and bond funds belong in a well-diversified portfolio to provide a measure of safety.

"You like to have some bonds maturing, so you can dollar-cost average into the higher rates," she said.

Contact Amy Higgins at 768-8373;; or 312 Elm St., Cincinnati 45202. She regrets that she cannot reply to all individual questions.

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