Much discussion currently centers on rising interest rates and the impact on bond mutual fund holdings in a 401k plan. The Federal Reserve has kept the Federal Funds rate at 0.25% since December 16, 2008 and has taken the position that until unemployment is below 6.5% or inflation is above 2%, no action will be taken to raise the Federal Funds rate. In addition to a Federal Funds rate that almost certainly has only one direction to go, which is up, currently the Fed is also providing “Quantitative Easing” or “QE.” On a monthly basis, the Federal Reserve has been purchasing $85 billion of bonds, of which $40 billion is agency mortgage-backed securities, and $45 billion of longer-term Treasury securities. This Quantitative Easing has artificially kept longer-term interest rates low, and provided most of the fuel to the housing recovery seen in the U.S. in the last year. The reality is that if this pace of asset repurchases slows or when it eventually stops, a steepening of the yield curve (higher interest-rate increases the farther out in maturity relative to shorter maturities) will be priced-in relatively quickly, negatively affecting a bond’s market value. Sounds horrible to a bond investor: losing money.
However, if you have a relatively long investing horizon as most participants do in a Qualified Retirement Plan or if you are entering retirement in a few years, there is some upside to rising rates.
- Coupon/interest/dividend payments will be higher on newly issued bonds. This will help the retirees and “savers” relying on relatively safe investments to gain more income in order to cover fixed expenses and/or grow principal.
- Assuming the bond fund is set to reinvest dividends and capital gains, then each reinvestment is buying shares at a lower price because the rise in interest rates caused the value of the underlying bonds to fall. This is the principal advantage behind dollar cost averaging. Not only will the dollar amount of each payment be higher due to interest rates, but as the share balance grows, so will the payment, because as it is based off number of shares. This is the advantage known as compounding.
In summary, the most important thing to consider is that the recent negative performance of your bond fund holdings, which may continue into the near term future, has an upside: those bonds that have lost market value will return their principal or “par” upon maturity, unless default, and those dividends and capital gains reinvested over the period of negative returns will actually aid in long-term performance.
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