Asset management is a careful process of mixing the right balance of stocks, bonds and cash reserves for the purposes of retirement or long term investing. With limitless variables in the markets, you’ll find that a single investment could drop in the double-digit range. The ultimate goal of asset management is to have a portfolio that can withstand a downturn in any sector. Think about the internet boom of the 90s and the stock market crash of 1929. Both events created a fear among investors that made it scary to invest in the market.
But it doesn’t mean that the bond market is immune from radical changes. Bond markets, too, go through cyclical changes that can mimic stock market shake-ups. Recently, in the 2000s, the bond market went through a tremendous drop because of rising interest rates.
So how do we protect ourselves from dropping bond prices in our asset management plan? Here are some ways to weather major downturns in the bond market.
Understanding Interest Rate Risk
Before we address methods to protect ourselves, we need to understand interest rate risks with bonds.
Interest rates for bonds fluctuate like stocks. The bond par value, which is like the stock price, can go up or down based on demand in the bond market. Demand is determined by how valuable a bond is for someone at a certain interest rate. If the bond provides a great rate in an environment where interest rates are going down, then the investment should go higher. Conversely, if the bond has low interest rates, while interest rates are rising, the par value would go down. Bond rates are tied to the discount and federal funds rate, which could go up or down, depending on factors such as the Federal Reserves and supply and demand. We have many more Investing Help Articles Now Available.
For responsible asset management, Treasury Inflation Protected Securities (TIPS) are a great way to hedge interest rate hikes in asset management. Usually for bonds, as inflation rises, the prices go down. Now you have a bond that can do the opposite. TIPS are investment vehicles by the US Treasury that allow you respond to inflation increases. The investment vehicle holds bonds with part of the assets that responds to inflation.
TIPS may not be perfect for everyone. They might not necessarily correspond to interest rates because they are pegged to inflation. More so, they may not provide returns like a treasury bill does because of the inflation-based protection.
Short Term Bonds
Short term bonds have a shorter maturity. And as such, they provide less volatility versus long term bonds. If interest rates were to go up, long term bonds would face a steeper drop than a short term bond. Why? Long term bonds, like 30-year treasuries, hold more risk. We do not know what the interest rates for borrowing would be like for the next 30 years. However, for the next 1-2 years, it’s easy to estimate interest rates. Short term bond values would slightly be affected by rates.
If you want to dramatically reduce interest rate risk, consider money markets. Money markets provide a safer haven. These investments buy ultra short term bank paper or debt instruments for corporate and municipal borrowing. They generally have a maturity of 30 – 60 days. Because of the low risk of default, the price of a money market usually stays at $1.00. Interest from a money market account doesn’t fluctuate as a long term bond would.
These are a few of the investment alternatives if you feel that bonds are becoming too risky, especially with rising interest rates. Consult with a financial planner for more help on your asset management. We have many more Investing Help Articles Now Available.