Minimizing interest rate risk in retirement income portfolios
Courtesy Strategic Financial Partners, Colorado Springs LIVING WELL Magazine
Fixed income investments such as bonds often hold a prominent place in the portfolios of investors looking for retirement income. While fixed income investments are typically less volatile than equities, they also come with risks, one of which is the risk that changes in interest rates will negatively affect investments. This is known as interest rate risk.
How interest rate changes affect fixed income securities
Interest rates typically go up when the economy is growing rapidly, and often go down when economic growth is slow or the economy is contracting. Fixed income securities, such as bonds, are directly affected by changes in interest rates.
Bonds offer a rate of return guaranteed by their issuer. When interest rates rise, investors who want to get rid of bonds will have to sell at a discount to compete with new bonds offering higher rates of return. The opposite is true when interest rates fall – bond prices usually increase, and sellers receive a premium.
The bond’s market value does not affect the amount or frequency of the payments the bond issuer makes. An investor who purchases a bond and holds it to maturity will realize a return that matches the bond’s coupon rate.
Example: Interest rate risk by the numbers
You purchase a $10,000 5-year bond, with a 5% coupon or interest rate. Interest is paid every six months.
- One year later, interest rates on five-year bonds are now 6%.
- With the rise in interest rates, you want to purchase additional bonds to take advantage of the increased rate of return. You consider selling your 5% bond before maturity. To be competitive in the bond marketplace, you need to lower the price. Potential buyers of your bond want to receive a return equal to the 6% payment available with new bonds.
How much should your bond be discounted to give the buyer a 6% return?
Existing bond = $10,000 at 5% interest
New bond = $10,000 at 6% interest
Adjusted price of existing bond = (5% / 6%) x $10,000 = $8,333
You will have to sell your bond for $8,333 for the buyer to earn 6% interest.
These are hypothetical examples for illustrative purposes only. They are not indicative of any particular investment or guarantee of future performance.
- The opposite is true if rates decrease. If rates dropped from 5% to 4%, your bond would be worth more than new bonds coming to market. The math is the same:
Existing bond = $10,000 at 5% interest
New bond = $10,000 at 4% interest
Adjusted price of existing bond = (5% / 4%) x $10,000 = $12,500
Bonds with longer terms are more risky than bonds with shorter terms, because of the increased possibility that interest rates could rise at some point before the bond reaches maturity.
Decreasing your exposure to interest rate risk
To counter the effects of changing interest rates, consider:
- Investing in short or intermediate-term bonds. They are generally less affected by interest rate changes than longer term bonds.
- Holding bonds to maturity – This allows you to earn the coupon rate while you own the bond, and receive your principal back when the bond matures.
- Creating a fixed income ladder – Systematically purchasing securities with different maturity dates is known as “laddering.” As bonds mature, they are redeemed at the original value and the proceeds are then invested at current market value or prevailing interest rates. Because bonds are purchased at different times, retirees are less likely to have an entire portfolio of bonds with low interest rates.
- Invest in bond funds – Mutual funds comprised of a variety of different bonds provide asset diversification as well as professional management.
Refer to the ad on page 1 or contact John Ferguson, CLU, CFS, AIF® and President of Strategic Financial Partners directly at 719-548-8511.
Note: A sound investment strategy requires consideration of a number of factors that go into creating a portfolio that fits your needs. Talk to your financial advisor to determine if fixed income securities are appropriate for you.
Investments in fixed income securities are subject to the creditworthiness of their issuers and interest rate risk. As such, the net asset value of bond and real estate funds will fall as interest rates rise. Investments will fluctuate and when redeemed may be worth more or less than when originally invested.
You should consider the investment objectives, risks, charges and expenses of a mutual fund carefully before investing. The portfolio and variable insurance product prospectuses contain this and other information. You may obtain a copy of the prospectus from your representative.
Please read the prospectuses carefully before investing.
Securian Financial Group, Inc.
Securities offered through Securian Financial Services, Inc., Member FINRA/SIPC
400 Robert Street North, St. Paul, MN 55101-2098
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