Many observers predict that interest rates are headed up from today’s low levels. Such an increase would be bad for bond investors because bonds lose value when rates increase. However, some tactics can reduce the risk:
1. Build a bond ladder. If you own bonds maturing in, say, 2011, 2012, 2013, etc., out to 2018 or 2019, you’ll have a bond maturing reach year. If interest rates have moved up, you can buy a new bond that pays a higher yield.
2. Buy a bond fund and reinvest all distributions. Say you invest in a bond fund in 2010, yielding 4%. Suppose interest rates rise to 5% in 2011, and go to 6% in 2012.
In 2011, your total return would be negative because falling bond prices would exceed your interest income. However, as your reinvested distributions and any maturing bonds are reinvested at higher yields, the fund’s return would rise. After seven years, you would have a higher total return than you would have had if rates had fallen or remained the same.
