Managing Bond Risks When Interest Rates Rise American Electric Power

As the Federal Reserve tightens monetary policy, American Electric Power employees should review their bond holdings to hedge interest rate risks, 'said,' a statement. Strategic adjustments in bond duration and diversification, like bond ladders, can moderate sensitivity to rate changes, says Michael Corgiat, a representative of The Retirement Group, a division of Wealth Enhancement Group.

Considering projected hikes in the federal funds rate, American Electric Power retirees need to be flexible about their investments, she said. ''Building a broad bond ladder can be a way to generate Retirement income while also being flexible to changing economic conditions,'' says Brent Wolf of the Retirement Group, a division of Wealth Enhancement Group .

In this article:

1. Rising Interest Rates on Bonds: Increased federal funds rates affect the bond market and investor strategies.

2. Managing Bond Investment Risk Mitigation Strategies Methods such as bond laddering and holding bonds of different maturities to manage interest rate sensitivity are detailed.

3. Alternatives & Adjustments for Retirement Portfolios: Discussion of using bond funds, ETFs, and UITs as adaptive strategies for American Electric Power employees and retirees amid rising rate environment ''

Because of higher inflation, the Federal Open Market Committee is now raising the benchmark Federal funds rate to more typical historical levels - from 0% -0.25% early in the pandemic. The Committee raised the funds rate to 0.25% -0.50% at its meeting in March 2022 and forecast six more quarter-point increases in 2022 and three or four in 2023.

An increasing federal funds rate pushes up all sorts of interest rates, including the cost of financing via bond issues. Bonds are a staple for investors seeking income or protection from stock market volatility in any rate environment. You might wonder how rising interest rates will affect your fixed-income investments and what you can do to hedge the effect on your portfolio.

Rate sensitivity

With rising interest rates come falling bond prices, according to a report by Forbes in January 2022. This is because the fixed-income payments that the bond provides become less attractive than other investments that may pay higher returns. A rising rate environment may make investors wary of committing funds for an extended period of time, so bonds with longer maturity dates are typically more sensitive to rate changes than bonds with shorter maturities. Hence, holding short- and medium-term bonds can help you hedge interest-rate sensitivity in your portfolio. Yet even American Electric Power employees and retirees should remember that these bonds are less sensitive to rate changes than longer-term bonds but typically yield a lower yield.

More specifically, interest-rate sensitivity is measured by duration. The duration of a bond is based on the maturity date, the present value of principal and interest due in the future, and other variables. The duration is multiplied by the expected percentage change in interest rates to estimate the effect of a rate change on bond investments. For example, if interest rates rise 1%, a bond or bond fund with a three-year duration would lose about 3% and one with a seven-year duration would lose about 7%. The duration of your bond investments is available from your investment professional or brokerage firm.

The longer bond with the higher yield usually has the same maturities as the other bond. This makes U.S. Treasuries more sensitive to changes in interest rates than corporate bonds of comparable maturities. The federally backed Treasury securities that are guaranteed to pay principal and interest on time are considered less risky and can command lower interest rates than corporate bonds. A five-year Treasury bond lasts less than five years because interest payments were received before maturity. But a five-year corporate bond with a higher yield is even shorter.

If the issuer does not default, a bondholder holding a bond to maturity will get the face value plus interest. However, prematurely redeemed bonds may be worth more or less than their face value. Hence, rising interest rates should not affect the return on a bond held to maturity but may affect the price of a bond sold on the secondary market before maturity.

Bond ladders

Employees and retirees of American Electric Power can own a diversified mix of bond types and maturities. This may reduce the portfolio risk of fixed-income investments. Structured risk management involves the construction of a bond ladder - a portfolio of bonds with maturities spaced at regular intervals over a number of years. For example, 20% of bonds on a five-year ladder may mature each year.

Because rate expectations for the next two to three years are expected to rise further, a short bond ladder now may be wiser than a long bond ladder once rates appear to have stabilized. And employees of American Electric Power should understand that the projected path of the federal funds rate is a projection of what may happen. Change in the actual trajectory of interest rates.

Laddering ETFs and UITs If the bonds are held to maturity, building a bond ladder is certain but expensive. Individual bonds typically have a face value minimum purchase of USD 5,000, so constructing a diversified bond ladder might take a big investment. Diversification reduces risk in investments. Nonetheless, it does not provide a profit guarantee nor cover investment loss - even for American Electric Power employees and retirees.

Similar strategies involve laddering bond exchange-traded funds (ETFs) with defined maturities. These ETFs contain large holdings of bonds that mature in the year the ETF liquidates and returns assets to shareholders. Target-maturity ETFs add diversification and liquidity, but unlike individual bonds, the income payments and final distribution rate are not predictable.

Optionally, investors could purchase staggered maturity unit investment trusts (UITs). Most bond-based UITs hold a diversified portfolio of bonds whose maturity dates match the trust termination date, after which you can reinvest the proceeds as you please. The UIT issuer may let investors reinvest the proceeds in a new UIT that carries a sales charge.

Bond funds

These bond funds contain mostly bonds and other debt and are subject to the same inflation, interest rate, and credit risks as their underlying bonds. Thus rising bond prices can hurt a bond fund. Since longer-term bonds are usually more sensitive to rising interest rates, funds holding short- or medium-term bonds might be more stable as interest rates rise.

Bond funds have no fixed maturity dates - except for target maturity ETFs - because bond funds typically have bonds of varying maturities and can buy and sell bonds before they mature. Therefore consider the fund duration taking into account the duration of underlying bonds. More duration means greater sensitivity to changes in interest rates. Duration is usually included among other details about a bond fund. Duration is useful as a general guideline only when comparing funds against similar underlying bond types.

The sensitivity of a fund to interest rates is only part of its value; Market and economic dynamics may affect fund performance. And as underlying bonds mature and are replaced by higher-yielding bonds in an environment of rising interest rates, the fund's yield and/or share price may rise over a longer period. Even short-term, the interest payments from the fund could cushion any share price declines.

Remember also that fund managers could react differently if falling bond prices hurt a fund. Others may reduce interest payments to keep the fund's asset value at the cost of its yield. Some will preserve a fund's yield at the cost of its asset value by putting money into longer-duration or lower-credit-quality bonds with higher yields but higher risk. The prospectus and other fund-related information may contain information about the fund's management, objectives, and flexibility in achieving those objectives.

The yield and principal value of individual bonds, UIT units, mutual funds, and ETF shares changes with market conditions. Fund shares, UIT units, and prematurely redeemed bonds may be worth more or less than their original cost when sold. ETFs typically have lower expense ratios than mutual funds but you pay a brokerage commission when you buy or sell ETFs; therefore, your overall costs may be higher if you trade frequently. According to supply and demand, ETF shares may trade above or below the underlying shares' value. UITs could also be vulnerable because of the possibility of an issuer's financial condition deteriorating. Ending a UIT and transferring an investment into a subsequent UIT may have tax implications. But working with a financial professional does not necessarily mean better investment performance, we want to remind American Electric Power employees and retirees.

Interest rates are like the tide of the economy - they can lift all boats but strand some too. And when interest rates rise, it's like a tide coming in - pushing some boats higher and stranding others on land. Like boaters who pay attention to the tide change their plans likewise investors who pay attention to interest rate changes adjust their investment strategies. As a captain must ride the current to shore, so must investors ride changing interest rates to shore.

Added Fact:

A recent Vanguard Group study found that older adults have higher allocations to bonds in their investment portfolios than younger people. Bonds can bring stability and income - but they also carry a risk when interest rates go up. The study suggests American Electric Power employees and retirees consider adding other fixed-income investments besides bonds, such as bond funds or target-maturity ETFs. They may find these alternatives flexible enough to help cushion the downside of rising interest rates. By exploring other investment vehicles, American Electric Power retirees can hedge bond risks and adjust to changing market conditions. (Source: The global case for strategic asset allocation & home bias examination, Vanguard Group, January 2022)

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Added Analogy:

It is like sailing a boat against the current to invest in bonds when interest rates are rising. As a sailor would adjust course and watch the tide change, so investors must adjust to higher interest rates on their bond investments. Risen tides can raise some boats to new heights and strand others below. Similarly, rising interest rates may change bond prices in different ways. Just as a skilled sailor tweaks their plan to tap into the power of the current, investors can hedge the risk of rising rates by acquiring more bonds, short-term bonds, or other investments. Knowing how to ride the waves of interest rates can help American Electric Power retirees steer their investment portfolios toward more calm waters and reach their financial goals.

Sources:

1. Chris. 'How Higher Interest Rates Are Impacting Retirees.'  Retirement Stewardship , 2023,  www.retirementstewardship.com . Accessed 24 Feb 2025.

2. Aliaga-Díaz, 'Why Higher Yields May Be Good for Many Retirement Investors.'  Vanguard , 17 Nov 2023, corporate.vanguard.com. Accessed 24 Feb 2025.

3. Turner, Kevin. 'How Rising Rates Impact Defined Benefit Plans.'  Russell Investments , 2023, russellinvestments.com. Accessed 24 Feb 2025.

4. Marketing Team. 'Navigating the Impact of Rising Interest Rates on Your Retirement Plan.'  Fintuity , 7 Jul 2023, fintuity.com. Accessed 24 Feb 2025.

5. Kitces, Michael. 'Adjusting Retirement Portfolios in Response to Rising Interest Rates.'  Morningstar , 2023, morningstar.com. Accessed 24 Feb 2025.