How do rising interest rates affect bond investors? Here’s how ...

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The sharp rise in interest rates recently is stoking fear among investors who poured into fixed-income in recent years.

And there’s plenty to be worried about if rates keep climbing. But how higher rates might affect you depends on several factors, starting with how long you plan to hold your investment.

Here’s a quick primer:

Let’s say you invested $10,000 in a bond paying interest of 3% a year. Assume rates rise and new bonds yield 5%. You’d still earn 3% on your bond, and you could boost the overall return on your portfolio if you bought a new 5% security.

But if you had to sell, your old 3% bond no longer would be worth $10,000. That’s because investors now could get a 5% yield for the same money. Your holding now may be worth only $9,500. That’s the crux of the issue: Rising rates on new bonds hurt the market value of older, lower-yielding securities.

If you invest through a bond mutual fund, its value has dropped. But the news is not all bad if you have the time or desire to hold on.

As each 3% security matures, the fund would buy 5% bonds. Over time, two things would happen. First, the 3% bonds eventually would mature, so the loss in market value would disappear. And the long-term return of the fund slowly would rise with all those 5% bonds.

Depending on the fund’s holdings, though, none of that would happen immediately. And this scenario could be upset if investors began yanking money out of the fund, forcing the fund manager to earmark free cash to pay departing investors rather than to buy higher-yielding bonds.

The bottom line is that rising rates could create a paper loss in the short term and an actual loss if you sold. But rising rates eventually could bring higher long-term returns if you held your investment long enough.

-- Walter Hamilton