One of the biggest challenges investors face today when investing for income is a low interest rate environment, the high price of stocks and bonds, and the possibility of a correction in both.
There are many current world events that can cause a correction in the stock market such as the Middle East contagion, the Japan nuclear and radiation containment issue, the United States growing debt problem or the European credit crisis that doesn’t seem to ever get much attention, but will continue to spread throughout various countries such as Portugal, Spain, Italy and others.
A correction in the bond market can be caused by either rising interest rates or a deterioration in credit quality of bonds. Let’s not forget the looming municipal and state deficit shortfalls that must be addressed.
One of the largest misconceptions we face is that the federal reserve controls interest rates. This may be true for the overnight bank lending rate, but the longer term rates are mainly market driven over the long term and many bond analysts believe we are seeing the end to a 30 year bull market in bonds which will produce higher rates over the next several years. The good news is that income investors should be able to realize a better return in fixed income investments if rates are higher, however those that are currently holding bonds and other investments sensitive to interest rate movements, can experience a decline in price of their existing investments during a rising interest rate environment.
There are a few ways to protect our investments from rising interest rates. One type of investment you can look at are floating rate investments. These are funds or investments that investing in bonds the should increase in value and income as interest rates increase.
Another method is to invest in very short term or short maturity investments now and wait until rates rise to reinvest at higher return. This method should preserve your principal today, but doesn’t help to produce a lot of income due to the lack of interest available for short term bonds.
The most common method is to ladder a portfolio of many different maturities and continuously reinvest as your bonds come due, at higher rates if in fact they are rising. You may experience a deterioration of principal value at the longer maturities, but your income should continue to flow as long as the credit quality of the bonds you purchase remains good.
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Remember, always invest with vigilance.