April 2, 2022

Should you invest in bonds right now?

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Written by: Lucien Paulemil

The FED has signalled its intent to raise interest rates.
What does this mean for bond investors?

The Federal Reserve’s January meeting confirmed what many investors expected: bond purchases should end in March and the Fed will raise rates by 25 basis points at least a few twice in 2022.

While many analysts focus on what this means for equities, others ponder how these measures will affect the fixed-income market.

Recently, bondholders were crushed by low rates and seemingly endless Quantitative Easing.

Will the Fed’s interest rate increase bode favourably for fixed-income investors?

What strategies should investors implement to take advantage of the upcoming rate hikes?

Here are 3 things to consider before investing in fixed-income securities.

  1. Understand the relationship between interest rates and bond prices

The first thing investors should do is understand the inverse relationship between bond prices and interest rates. Contrary to popular belief, interest rate increases do not increase bond prices. In fact, they decrease them.

Here’s why.

Most bonds pay a fixed annual interest rate – called a coupon – that becomes more attractive if interest rates fall. If your bond has a better yield than newly issued bonds, investors will be willing to pay a greater price for your higher-yielding bond.

Image source: Econowaugh AP

If, on the other hand, interest rates rise, your bond will be yielding a lower rate than newly issued bonds. Thus, demand will dry up and the price of your bond will decrease to offer a similar yield to the new bonds with higher coupons.

We can see this phenomenon in action with US Treasury Yields.

As interest rates are expected to rise, bond prices are falling and bond yields are increasing. Investors holding bonds have to sell them at a lower price to compete with the new bonds that will be issued with higher coupons.

source: Bloomberg

It is crucial that investors interested in fixed-income securities understand this inverse relationship between bonds and interest rates.

  1. Invest in short duration bond portfolios

If you are anticipating an increase in bond prices, you should invest in short duration bond portfolios.

First, bond portfolios with short duration are less sensitive to interest rate fluctuations. If you invest your money in this type of fund, you can park your cash safely while you wait for newly issued bonds to offer higher coupons.

Some quality short duration bond portfolios include:

  • Vanguard Ultra-Short Bond ETF (VUSD)
    • Fund objective: Provide current income while maintaining limited price volatility.
    • Portfolio: Medium and high-quality fixed-income securities with 1-2 years to maturity.
    • Expense Ratio: 0.10%.
    • Average Annual Returns: 1.40% over 3 years, 1.39% over 5 years and 0.89% over 10 years.
  • Vanguard Short-Term Bond Index Fund ETF (BSV)
    • Fund Objective: track the performance of the Bloomberg U.S. 1-5 year Government/Credit Float Adjusted Index.
    • Portfolio: Medium and larger issues of the US government, investment-grade corporate bonds, and investment-grade international USD bonds with 1-5 years to maturity.
    • Expense Ratio: 0.05%.
    • Average Annual Returns: 2.35% over 3 years, 1.99% over 5 years, 1.60% over 10 years.

Other quality short duration bond funds include:

While you won’t generate market-beating returns, these funds allow you to place your capital in a safe haven while you wait for the Fed to increase rates.

  1. Buy bonds when interest rates have increased

If you’re thinking of buying individual bonds on the secondary market, buy them after interest rates have been raised.

If you buy bonds before the interest rates increase, the rate increases will devalue your bond, and you will incur a capital gains loss if you sell it back to the markets. In addition, your coupon will be lower than the newly issued bonds.

Thus, you should only buy bonds once the rates have increased and the newly issued bonds reflect the new rates.

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