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The Federal Reserve’s recent decision to leave its benchmark interest rate unchanged is a stark reminder that predicting interest rate movements is notoriously difficult — much like predicting stock market returns.
Indeed, before 2008, who could have predicted that the U.S. overnight rate would be near zero for such a long time? Who correctly predicted that Japan’s “real” (i.e. inflation-adjusted) interbank rate would be negative for the past 20 years? And who could have foreseen that central banks in some European countries would actually have negative stated interest rates?
So what are retirees and soon-to-be retirees supposed to do about their fixed income portfolios? As you may know, rising interest rates reduce bond values. While this might not be a problem for investors who plan to hold their bonds until maturity, those of us who own bond funds (which hold bonds of varying maturities) need to be sure we are protecting ourselves in case interest rates rise again.
To do so, we borrow a solution from our friends in the public health arena: Be wise, immunize! Of course we’re not talking about preventing disease. Rather, we’re talking about a very important strategy for investors with heavy concentrations of bond holdings — immunizing their bond portfolios.
In portfolio management, immunization refers to protecting a fixed income portfolio against interest rate risk. The investor — or the investor’s advisor or portfolio manager — adjusts the average duration of the portfolio to the expected time horizon of the investment. (For less-experienced investors, it’s important to understand that with bonds, duration is not the same as maturity, although both are measured in years. Maturity simply tells you when a bond will come due; duration is a more complicated concept that reflects sensitivity to interest rates.)
In other words, if a 55-year-old investor estimates that she would like to retire in eight years, the average duration of her bond portfolio should be eight years. This means that the investor can lock in at the current prevailing yield for the portfolio’s credit and maturity profile, and because the duration matches the investment horizon, changes in interest rates won’t affect the holdings. With this strategy, investors don’t have to worry that an interest rate increase would cause more losses in principal than the reinvestment of the bond portfolio’s interest payments could offset.
As you can see, portfolio immunization takes into account intermediate investment concepts like duration and reinvestment risk. However, it’s relatively easy for a do-it-yourself investor to get duration information on their bond funds. Most financial websites or fund-reporting tools make that data available.
Whether you want to try this on your own or with the help of an advisor, in the end, it’s most important for older investors to remember that a bond portfolio can lose value during rising interest rates. So make sure your bond portfolio is “immunized” as much as is possible, especially if you are nearing retirement. Neglecting to do so can easily make any bond portfolio extremely ill, should interest rates rise significantly. And that won’t leave you feeling too hot, either.
This article also appears on Nasdaq.
Image via iStock.