Rising bond yields should be good news for investors, right? In fact, when bond yields rise, the market price of existing bonds goes down. That can lead some investors to think it’s time to sell their bonds. But there are important reasons to stay invested – including wealth protection and predictable income.
How it works:
When a bond’s yield falls, its price rises; conversely, when a bond’s yield rises, its price falls. When interest rates rise, they often raise yields with them. In turn, rising yields can trigger a short-term drop in the value of existing bonds. That’s because investors will want to buy the bonds that offer a higher yield. As demand drops for the bonds with lower yields, the value of those bonds will likely drop too. However, this near-term view overlooks the longer-term payback of higher yields. Capital losses in the short term can set the stage for higher future returns.
Don’t throw your bonds out with the bath water
Despite the sharp rise in yields, and the consequent downturn in prices, it is important to remember that bonds have long been a stalwart defender of wealth and income, providing three essential components that together help support their importance in a risk-appropriate portfolio:
- Income: Bonds generate income through coupon payments, which are quarterly or semi-annual payments of interest from the issuer made throughout the lifetime of the bond. This provides a steady return to investors regardless of market conditions and the existing, day-to-day market value of the bond. This flow of income can be extremely important, especially for those, like retirees, who depend on the income generated from their portfolios to live on. Coupon payments can also be re-invested as they are paid out, something that can be advantageous when interest rates and yields are rising.
- Protection: Generally speaking, when investment markets become volatile, usually as a result of uncertainty or crisis, bonds increase in value. This is based on two important aspects of their structure: one, they are a specific commitment on the part of the issuer to repay the face value of the bond, and on a certain date, unlike equities that exist in perpetuity and have no maturity value; and, two, when interest rates are cut or reduced as they often are in times of stress, this lowers yields and increases prices for bonds (see diagram above).
- Diversification: A fundamental principle of successful, long-term portfolio management is diversification – the old “Don’t put all of your eggs in one basket” adage. As asset classes such as bonds and equities usually move in opposite directions from each other (they are “negatively correlated”), that means that when things are going badly for equities, your bond portfolio will often perform much better, offsetting one for the other and smoothing out your portfolio returns over time.
Keep the faith
Despite their recent volatility, bonds have long been a critically important foundation for most investors’ portfolios, offering important protection and income flows that offset periodic periods of price pressure. Before you lose faith with this important asset class, talk to us about how bonds can help you achieve your long-term investment goals.
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