May 4, 2018 4 min read

The Federal Reserve had its regularly scheduled meeting this week and decided to leave interest rates unchanged. This is the outcome the stock market expected.

The Fed also noted inflation was picking up.

The Fed has two main functions. When the economy is slow, it tries to stimulate growth with lower interest rates. It has been doing that for the past nine years.

When the economy begins to overheat, the Fed takes actions to slow it down. Inflation is the way it measures how hot the economy is growing, and the Fed accomplishes this by raising interest rates. It is expected to do this two or three more times this year. There could be a bigger-than-expected interest rate hike if inflation increases faster than expected.

There are several types of bonds issued by government or corporate entities. You are lending money to the issuer when you buy a bond, and the issuer promises to repay at a certain time while paying you interest. When lending your money, you have to wait until maturity to get it back. Sometimes, you can sell to another investor in a secondary market.

Some bonds are for short periods, some for decades. This length of time is known as duration. Because long-duration bonds can last for 20 or 30 years, investors usually demand higher interest rates.

The credit quality of the issuer also is a major determinant of interest rates. If financially strong companies are paying 3 percent interest, that is likely to be the rate companies with similar financials would probably have to pay to sell bonds. If a company is having financial issues, it will have to pay a much higher rate of interest to attract investors.

These bonds are known as junk bonds because if the company goes bankrupt, you could lose all of your money.

Bond values are always affected by changes in overall interest rates. The longer the duration to maturity, the greater the effect. Sometimes the value of bonds goes up (when interest rates in general are going down); sometimes the value of bonds goes down (when rates are rising). Remember, the interest rate the actual bond is paying does not change. What does change is the amount of money you could receive in a secondary market if you need to redeem your investment before maturity.

A bond maturing in a short period does not react as much as one with many years. If you own bonds that have 20 years to maturity and you need to sell and get your money back for retirement or some other use, you will lose “principal” and realize a loss when you sell. This could be substantial.

The reason this happens is new investors will naturally want the highest yields available with the same amount of credit risk. If you want to sell your 3 percent bond when overall rates have risen to 5 percent, you will have to sell at a discount to find a buyer. The buyer is only willing to pay a face amount that will net him the current interest rate. He will get full value from the issuer at maturity as long as the issuer has not gone bankrupt.

Many people believe that bonds are a safe part of their market allocation. This is not true in an environment in which a rapid rise in interest rates is possible. Be sure that your investment portfolio reflects current financial conditions.

Gary Boatman is a Monessen-based certified financial planner and author of “Your Financial Compass: Safe passage through the turbulent waters of taxes, income planning and market volatility.”

To submit columns on financial planning or investing, email Rick Shrum at rshrum@observer-reporter.com.