What the Fed’s Interest Rate`Surprise’ Means For Bond Investors

Last week, I warned not to let fears of rising interest rates cloud your investment decisions. On Wednesday, we saw why.

While speculation has been building for months that improving economic data would prompt the Federal Reserve to begin increasing interest rates, the Fed threw the market a curve and repeated earlier statements that it will keep interest rates and their low levels for a “considerable time.”

The Fed is continuing to cut back on its bond buying program known as quantitative easing, but the central bank has also made it clear that it doesn’t see ending its stimulus efforts as being synonymous with raising rates.

The Fed has kept rates at near zero since the financial crisis of 2008, and it has attempted to reassure investors by outlining plans of how long it intends to keep rates at the current level.

The Fed will, ultimately, begin moving rates up, perhaps sometime next year, but for investors, it’s way too soon to begin worrying about how a higher rate environment might affect bond prices.

Instead, the unexpected nature of the Fed’s decision underscores my point about buying short-term bonds – those maturing in one to five years. As I pointed out, each day that passes without the Fed taking means that a four-year bond loses another day of duration. In other words, by holding individual bonds, your risk diminishes daily.

And purchasing individual bonds with maturities of five to seven years may mean they have call provisions or other terms that would shorten their “average life.” This average life scenario is often depicted as “duration,” a calculation considering all the features of a bond in a mathematical “life” other than maturity. These types shorter duration bonds make more sense than sitting on cash and waiting for rates to rise.

While these bonds aren’t likely to pay the 5% offered by many funds, holding individual bonds is also a better alternative than trying to time the sale of your fund holdings to coincide with the rise in rates.

More important, though, it now looks as if any change in rates could be pushed farther down the road than many Fed watchers believed. The Fed’s Open Market Committee, which sets monetary policy, found a “significant” amount of slack remains in the labor market, following a weak August jobs report.

Government data released this week also showed inflation remained negligible, which contributes to the Fed’s lack of urgency in raising rates. In the meantime, investors are better served by extending their short-term bond purchases rather than trying to anticipate when the rate hikes may finally come.

Please see IMPORTANT DISCLOSURE information