Spencer Platt / Getty ImagesIf you’ve watched the news lately, you’ve noticed there is a lot of talk about interest rates.
So you might be asking: Why should I care? What’s the big deal? And will it affect me?
Besides determining the cost of a loan for your house or car, interest rates have a lot to do with … pretty much everything.
They can affect employment, foreign investments, the stock market, and ultimately, GDP. For example, they drive employment. Why? Because if a company can borrow at a low interest rate, they can use remaining funds to hire more people. But if interest rates are higher, they may not be able to employ as many people.
OK, great. So they run the world. Check.
Besides those effects, they can also have an significant impact on your personal investment portfolio. In particular, your bonds. Why?
When interest rates rise, prices of existing bonds go down. That’s because it’s a better deal for an investor to buy a brand-new bond that offers him a higher interest rate (let’s say where he gets $10 per year), instead of the old bond that you have (let’s say that it offers $7 per year). So the price of your old bond goes down.
Think of it like a phone — when you bought the iPhone 5 last year, it cost $300. As soon as the iPhone 5S came out — at a price of $300 and with other bells and whistles — your iPhone 5 was worth just a little bit less. Doesn’t mean you have to love it less, it just means someone else isn’t willing to pay $300 for it anymore.
The same dynamic is true with bonds. And, importantly for your portfolio, falling bond prices can have a big impact on your investments. If you own 10 bonds that are falling in price, your bond portfolio is worth less, which could lead to less money in your pocket.
One popular way to help guard against falling prices is to get access to bonds that are shorter-dated.
Next up on The Blog — how (and why) these shorter term bonds can help.
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.