Understanding the Interest Rate Risk in Your Portfolio

interest rate riskInterest rates greatly affect many personal finance choices. From refinancing mortgages for more affordable payments to transferring credit card balances for faster payoffs; historically low interest rates are helping Americans improve their finances.

However, making investment decisions can be more difficult in a low interest rate economy.

It is important to understand the degree of interest rate risk in your portfolio and rebalance investments accordingly if needed.

While investment strategies run the gamut, most everyday investors own fixed income in the form of bonds, CDs or savings accounts.

Simply avoiding fixed income investments or taking excessive risks for yield can also be costly.

Below is a summary of interest rate riskand some tips to manage for it.

Interest Rate Risk:

When investors own bonds making lower interest payments than other fixed income of comparable credit, interest rate risk has been realized.

If you own a long maturity U.S. Treasury bond and higher yielding investments with good credit ratings become available, you have interest rate risk in your portfolio.

Bondholders may realize a loss if they decide to sell these low performing bonds for money to buy more attractive investments.

Low paying and illiquid certificates of deposits have little market risk, but have high opportunity costs if U.S. Treasuries or investment grade bonds with higher coupon rates become available.

CDs or other conservative investments may have a place in your portfolio, but the allocation should be based on an investor’s unique situation.

Current Economy:

Interest rates are at historic lows, making it unlikely that higher paying bonds will be issued in the near term.

Investment Managers such as Elliott Broidy have utilized various strategies to balance the risk and reward of low interest rates.

Bond investors who want higher yields may assume greater risk with lower rated debt or turn to fixed income choices in overseas markets.

If interest rates begin to rise, those holding bonds issued at low coupons may seek out higher paying alternatives.

Your Portfolio:

Do you know the potential impact of interest rate changes on your investments?

Are these risks acceptable to you?

Managing interest rate risk is not about market timing. Rather, it involves accepting potential risks based on your investment goals.

Chasing performance returns is ineffective, but periodic rebalancing of asset classes and investments is beneficial.

Fixed income investing involves several considerations that include your tax bracket, risk tolerance and time horizon, among others. Investors should first understand these factors to make more prudent decisions.