There are many ways that the financial market can change. It can rise, fall, or go steady. And bonds react to these changes in the market, particularly in times of rising interest rates. The following are the strategies you can use in order to avoid negative returns on your bond holdings.
Maintaining Bond Positions
Perhaps the simplest way to avoid losses when interest rates rise is to buy individual bonds and then hold them until maturity.
Using this method, you can reasonably expect that you will receive your principal back at the maturity. This method also gets rid of the interest rate risks. The present bond price may slump when the rates increase. However, you will still receive your original investment back at the determined maturity date of the bond.
You can also get rid of the credit risk, particularly for the higher credit rated bonds since there is very minimal risk that the underlying company becomes insolvent and unable to pay back the debts. On top of that, liquidity risk is also wiped out by buying and holding a bond until maturity. You don’t need to trade it.
When interest rates rise, staying invested in your bonds with nearer term maturity can be helpful. Fundamentally speaking, the interest rate risk is less for bonds that have a closer maturity date. Bond duration, which refers to the sensitivity of a bond price to changes in interest rates, shows that prices change less for closer maturity dates.
At the shortest maturity date for money market funds, they adjust right away to higher rates and most of the time they do not lose any of the principal.
Generally, staying on the shorter end of the maturity schedule can help the bond investor avoid the negative bond returns. They also provide for a better yield in times of increasing rates.
Short Selling the Bonds
For more risk tolerant investors, there are opportunities for short selling. Similar to any other security, going short on bonds means borrowing the security and expecting a fall in prices. After the fall, the investor can buy it back and return what he or she has borrowed.
The market for short selling an individual bond is not really large or highly liquid. However, there are plenty of chances for individual investors to invest in short bond mutual funds and exchange traded funds.
Some other Things to Consider
There are many other strategies and combinations that you can employ to try and avoid negative bond returns. Hedging techniques are among them, such as using futures, swap spreads, and options to speculate on the rising or falling rates along the certain parts of the yield curve.
Inflation rates and anticipation for future inflation are also very important considerations when you are investing in bonds. There are inflation-adjusted bonds, like the Treasury Inflation Protected Securities, and they can help you reduce the losses that inflation can deal on real bond returns.
As explained, investing in bond funds can also be quite difficult during times of rising rates. However, they do have benefits in that the investor is outsourcing his or her capital to a professional that should have a fair level of expertise in specific bond tactics in a mix of interest rate environments.