Many investors want to invest in bonds as it assures a steady cash flow. Investors usually buy bonds when interest rates are low. But they are always concerned that a hike in the interest rate will render their bonds to lose their value. In this article, we will try to examine the rationality of this concern.
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The experts and brokerage firms often say that the rise in interest rates is inevitable. But none can predict a particular date or time when that might happen. The media also tries to predict the losses investors may suffer due to a rise in interest rate.
To cut losses the brokerage firms often recommend investing in the short-term bonds. However, if you have followed this advice, you must have experienced reduced cash flow and loss of compounding for many years. As an investor, you must understand that no one knows when the interest rates are going to rise.
If you want to invest in a bond, there are three possibilities you may face concerning interest rates:
Remember, no one can predict what will happen in the future for most of the time the investors remain clueless about the direction of the interest rates.
See Also: Understanding Bonds and Their Risks
The mark-to-market accounting was officially recognised in India in the year 2009 by the Financial Accounting Standard Board. It is a practice of valuing the assets at current market price. Using this method the daily return on your portfolio can be calculated accurately. Here the market return becomes your effective return if you sell on the day of a rise or fall.
The brokerage firms usually use the mark-to-marketing method but it is inappropriate for individual investors to use this methodology. The firms use this strategy to encourage investors to sell bonds rather than holding them until maturity. However, you should not be influenced by such charts and sell your bonds in a panic. Since the bond coupons remain unchanged, the income from bonds remains the same even if the interest rates go up.
Individual investors can consider the benefits of bond laddering.
You may ask what is bond laddering?
Bond laddering is a strategy wherein an individual buy bonds with varying maturity dates so that the investor can respond quickly to changes in interest rates. Bond laddering is a beneficial step and is easy to implement. You need to diversify your investment portfolio by purchasing multiple bonds according to your investment needs. You can ladder a large set of bonds with varying maturity dates.
Bond laddering can boost the income you receive from interest payments because long term bonds tend to pay higher interest rates. If your bond ladder is in place and the interest rates go up then you are likely to be benefitted. This is because as interest rates go up, you will be able to increase your cash flow by reinvesting your bond proceeds and your interest income into high yielding bonds.
You can consider the following guidelines while buying and holding your bond ladder:
Firstly, identify the years when you need cash. For example, if you want to buy a property in the next five years, and then invest in bonds that are due after five years. Keeping a cash cushion is important so that you can be a buy-and-ladder investor.
Secondly, consider the shape of your yield curve. The yield curve is a chart that plots the interest rates being paid by bonds of the same credit quality but different maturities.
Thirdly, if you create a ladder of bonds with short maturities then you are likely to be shielded from an interest rise in the future.
See Also: Bond Yield In India
Firstly, identify your objectives and your financial requirements. Once you know your necessities, you can save the rest for investing.
Secondly, determine your asset allocation. Invest in some safe investment options like building a bond ladder and how much you can use to speculate
Don’t worry about the interest rate going up as no one can predict the interest rate hikes
Set up a custom bond ladder so that you can receive a constant flow of cash
Invest in high quality tax-free municipal bonds
Relax after establishing your bond ladder. If the interest rates go up then you will surely benefit from it.
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