By Jeanne Sahadi, CNN Business

Iinflation is high and interest rates are expected to rise this year. What does it mean if you invest in bonds?

You’ve probably heard that when rates go up, bond prices fall. And if you already own bonds directly or through a bond fund, it is not good news.

But that shouldn’t stop you from invest in bonds. And there are ways to limit the downside of a rising rate environment to your portfolio and position yourself for more yield.

Bond basics

Forget rates for a minute.

There are two main reasons to invest in fixed-rate bonds, even if they offer lower returns over time than equities.

The first is to protect your portfolio against equity risk and volatility. In times of market routs and economic downturns, high-quality bonds – especially US Treasuries – are considered safe havens.

The other reason to invest in bonds is that they generate guaranteed interest income, which is usually paid twice a year. These interest payments are like stock dividends and can be reinvested. But unlike dividends, the interest payments on your fixed rate bonds will never change.

So even when bond prices fall, you continue to make money from your investment. “That steady stream of income, that’s always positive,” said Judith Ward, Certified Financial Planner, who is T. Rowe Price’s senior retirement information manager.

So why do bond prices fall when rates rise?

A simplified way to think about why bond prices fall when rates rise is as follows: all other things being equal, if someone could buy a 10-year bond paying 1.5% interest per annum or a shorter-term bond that pays more, they would probably choose the latter.

If you held this 10-year bond at 1.5% and wanted to sell it in a rising rate environment, the price should be low enough to attract a buyer who might otherwise get a better return elsewhere.

To protect your money, shorten

The bonds most exposed to price declines in a rising rate environment are those with longer maturities.

“The longer the maturity, the more price movement you’re going to have,” said David Sekera, chief US market strategist at Morningstar. “Maturity duration risk is the greatest risk to [bond] investors. »

So, in a rising rate environment, you should consider reducing the average duration of the bonds you hold, Sekera suggested.

Based on Morningstar estimates that the U.S. economy will grow 3.9% this year and 3.5% next year, he thinks the current sweet spot – where investors can get the best return in exchange for price risk – are 5-year bonds both on the government side and in companies. “This is where you get the best return for the risk you take.”

Between five-year government and corporate bonds, says Sekera he thinks companies — which pay more because they carry higher risk than Treasuries — will serve investors well. This is because he expects corporate defaults to remain low and that there will be more improvements than downgrades in corporate credit.

Shouldn’t the economy do like As Morningstar’s outlook suggests, there is likely to be less downward pressure on bond prices as the Federal Reserve would likely slow its rate hikes and investors would view bonds as a safe place to invest. their money.

Certified financial planner Clark Kendall, who runs wealth management firm Kendall Capital in Maryland, would also advise investing in bonds with shorter durations, as they will mature quickly and allow you to reinvest the money more regularly. into even higher yielding bonds.

Still, Kendall warns that regardless of rising rates, bond yields are unlikely to be staggering. So, for a higher return, albeit a bit more risky, he suggests investors consider investing in dividend-paying value stocks of large, stable companies that trade at a lower price relative to their earnings and their growth potential.

Diversify your bond portfolio

Another way to protect yourself in a rising rate market is to make sure your bond holdings are diversified.

Ward of T. Rowe Price recommends investing in a mix of US government bonds, investment-grade corporate bonds, as well as high-yield (aka “junk”) and corporate bonds. other countries, including those in emerging markets. “They might be on a different trajectory in terms of rising or falling rates, so they might not be in sync with the United States,” she said.

In the bond portion of a retirement savings portfolio, she recommends that 70% be invested in investment-grade US bonds, 10% in high-yield securities, 10% in international markets and 10% in emerging markets. .

When it comes to your overall bond-to-equity allocation, how much you should have depends on your age, time horizon, and risk tolerance.

Generally, the younger you are, the fewer bonds you should have, as you want to maximize the growth of your savings over time. And you have a long enough time horizon to recoup losses from the inevitable stock declines that will occur during your career.

But the closer you get to retirement, say in five to ten years, the more bonds you’ll want to have to protect your portfolio against risk of retirement right after or right in a bear market.

You should also build up your cash reserves, Ward said, to serve as a bear market emergency fund that you can draw on for expenses in your early retirement years, to give your stocks a fighting chance. to recover.

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