Do rising rates make bonds bad?

The recent rise in interest rates has caused many investors to question whether bonds are worth owning. That's because bond prices have an inverse relationship to interest rates; meaning when interest rates go up - bond prices go down. This explains why some bond investors saw negative returns in the 4th quarter of last year. This has investors considering whether they should own bonds moving forward.

Bonds can play an important role in a portfolio. Investors may own bonds for a variety of reasons - for example, to reduce portfolio volatility, generate income, maintain liquidity, pursue higher returns, or meet a future funding obligation.

A bond portfolio's role may vary according to an investor's financial needs and concerns. However, investors must weigh these priorities against their concerns over future rising interest rates that might affect fixed income returns. Striking this balance can be a challenge in any market environment, but especially now, coming off historically low interest rates. So, what's an investor to do?

Is panic selling the right answer in this situation? Should bond investors move into cash, stocks, or another investment to avoid future losses? The answer is no.

Recently, I've heard investors considering selling their bonds and buying stocks. After all the S&P 500 had a good return last year - why not? Because the risk/return characteristics of those two investments are different. That would be like a contractor selling his pickup truck and using a sports car for work - it's not the right tool for the job.

Also, you need to know the difference between controlling risk and avoiding it. You cannot eliminate risk in any portfolio, but you can manage your risk by diversifying across maturities, industries, countries, and currencies to reduce the impact of rates, inflation, currency fluctuations, and other risks. With the potential for rising rates on the horizon, it's probably not the best idea to load up on long term bonds since they are more sensitive to interest rate movements.

Also, a bad year for bonds historically is nothing compared to a bad year for stocks.

Another point to remember is that not all bonds are the same.

You have Treasury bonds issued by the US Government. You have corporate bonds, municipal bonds, high yield bonds, mortgage backed bonds, floating rate bonds, short term bonds, long term bonds, and foreign bonds. Not all of these bonds react the same way to rate changes. Rising rates is not a death sentence for bonds. If you're following a reinvestment strategy, you'll be reinvesting interest at higher rates. Many bond strategies have actually performed well in past rising rate environments if managed properly.

It's not too late to revisit your bond allocation. Make sure you have a good understanding of what type of bonds you own and their duration (interest rate risk). Review why you own bonds in your portfolio and monitor if they are fulfilling their purpose. It might be time to readjust your bond portfolio. A bond you bought 5 years ago might not be the best to own moving forward. As I mentioned, not all bonds perform the same in rising rate environments. No one really knows when and by how much interest rates will change. Pundits have been predicting rising rates for several years now and we've just recently seen them move up. Bonds can play an important role in your long term portfolio and most investors might be best served by building a fixed income strategy to complement their broader portfolio objectives.

• John P. Daly, is president of Daly Investment Management in Mount Prospect. John@dalyinvestment.com