What Happens To Bonds and Annuities If Interest Rates Rise
By Bill Broich|
Interest rate changes may hurt the value of your bonds
Will bond investors soon suffer significant losses if financial experts are right? Many experts such as Bill Gross and other soothsayers have warned of an impending bond bubble. While it has yet to happen, the threat remains and needs to be considered anytime retirement planning is the topic. This, of course, is the value of existing bonds being worthless if general interest rates were to rise and if sold on the open market, before maturity.
Quality bonds certainly have a place in a portfolio, and yet many investors who depend on this money for safety and security have their deposits moving elsewhere, such as into guaranteed annuities. Will, the Federal Reserve, raise interest rates, YES; the question that needs to be answered is when? The Federal Reserve will be motivated to increase interest rates; the timing of such a raise is the unknown factor. If the economy remains at just at moderate health, the need to explore risk will remain enticing. That desire is of course what keeps the stock market buoyant and flourishing. Once interest rates begin to climb, removing risk and jumping back into an interest-bearing account becomes almost a guarantee for many investors.
If you are a bond investor, what choice do you make, long, short of the safety of a bond mutual fund? Bond funds offer a wider chance of removing volatility, but the bond fund owner is faced with fees, expenses, and often commissions. Does it make sense to give away a percentage of your bond portfolio in fees? A bond fund owner needs to know the duration of the bond portfolio, research companies such as Morningstar will list them. This will provide the bond fund owner with an idea of how much the price could move up or down. The duration of a long bond could be 8 or 9 meaning for every 1% interest rate rise the bond price (NAV) would fall by 8-9% or increase in the falling rate scenario.
Also, in an increasing interest rate scenario bond fund owners may be faced with a decline in their account values. Typically longer termed bonds will suffer more in declining value by higher rates. The other option is to take a shorter position in bonds but if interest rates begin a more than once increase, being short can have a dramatically adverse effect. Experts agree and disagree; apparently, it all depends on the perch you have landed on. One well-used compromise is to outsource your bond portfolio to an insurance company by owning a fixed interest rate annuity. It still is bond-based, but the principal is fully guaranteed, regardless of where interest rates decide to drift.
Just a simple rate movement over time of 3% (3.25% discount rate) would reduce the actual value of all enforce US Treasuries by as much as 40% of their market value. Think what would happen if interest rates went even higher? Disaster would loom, and trillions of dollars would evaporate if these assets were liquidated. Of course, there would be a winner: the US Taxpayer. Treasuries would be replaced with a higher earning interest rate bond but at a far less value, a third of the market value of the original bond.
Bonds still belong in most portfolios, but it depends. In an increasing stock market buying a 20 year (or shorter) bond paying low interest might seem silly. Financial advisors will still recommend bonds as a way to balance a portfolio, but examine what balance means to you as an individual. What is the real purpose of money, safety, growth, income? There is no one-size-fits-all when it comes to designing a portfolio. We are all individuals, and our goals and needs are never the same.
The big picture and overall planning for most people seeking bond returns and perceived bond safety should also include annuities. Annuities are mostly bond-backed but far different than buying a bond fund or individual bonds. Insurance companies look at a far larger window for owning bonds, 40 years to be exact.
Volatility control is far more critical than growing or increasing yields in insurance company portfolios. Insurance companies buy 20-year bonds, so looking back over the past 20 years and forward today over the next 20 years gives insurance companies a far greater opportunity to avoid bond exposure. This extended period allows for maximum volatility control and makes it easier to position products for newer markets.
Annuities provide a far more significant benefit than buying bonds. Annuities allow for tax-deferred growth, protection of principal (without having to buy outside insurance), and an opportunity to provide income for a long secure time period, even a lifetime.
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