Are Bonds Risk-Free Investments? Managing Interest Rate Risk in Your Bond Portfolio

fter the stock market crash in 2008, many investors decided that they don’t want to take on risk by investing in the stock market. Instead, they have moved their investments to bonds, which they believe are risk-free. However, if we take a closer look at bonds, we will find that they contain their own significant sources of risk. Knowing how to manage this risk is the key to successful investing in bonds. In this article, we discuss interest rate risk, which is the risk of loss due to rising interest rates.
The reason interest rates pose a risk for bonds is that bond prices move inversely with interest rates. That means that if interest rates rise, bond prices fall. Interest rates are currently as low as they’ve been in a generation - it’s hard to imagine that they could go much lower. When interest rates eventually rise, bond investors could be in for an unpleasant surprise, as the value of their bond holdings will fall significantly.
How do you manage interest rate risk in your bond portfolio? The trick is to ensure that the average maturity of your bond holdings matches the time horizon in which you’ll need the money. The best way to do this is by purchasing a bond whose maturity date matches your time horizon. For example, if you need $10,000 in 10 years, you could purchase a 10-year bond with a face value, or a value at maturity, of $10,000. If you have an account with a broker, you can easily make this kind of purchase.
If you’re investing in a bond fund, the best thing is to tailor your fund holdings based on whether you would characterize your time horizon as short, medium or long. A short tome horizon would be less than five years, a medium time horizon would be five to 10 years, and more than 10 years would be a long time horizon. You can find fund families that have specific bond funds dedicated to each time horizon. For example, if your time horizon is five years, you should be looking for a fund that invests primarily in medium-term bonds. By matching the term of your bond holdings against your time horizon, you help insulate your portfolio from the risk of a loss of value due to rising interest rates, as the extra income that you receive from higher interest rates offsets the loss due to lower bond prices.
In summary, interest rate risk is controlled by matching the maturity of your holdings to your time horizon. Ideally, you should purchase a bond with a maturity date equivalent to your time horizon. In the context of bond funds, depending on whether your time horizon is short, medium or long, look for a fund that invests in bonds of that type. Being educated about managing interest rate risk in your bond portfolio will help you to be a smart and successful bond investor.