Although interest rates fell precipitously in the early 1980s, they are now on the rise through the Federal Reserve System. Higher rates will resonate through virtually every sector of the economy, including investments; more specifically, the increasing interest rates can be bad for bonds. And many fixed- income investors are asking where they should turn.
When interest rates rise, new bonds pay a higher yield, which is good for new bond buyers. However, it is bad for existing bondholders, because their bonds, which pay less interest, are less attractive and therefore decline in price.
Variable rate instruments
Investors who are concerned about the potential impact of higher interest rates on their existing portfolios have options in variable rate instruments, which are securities that do not offer a fixed rate of interest. The rate of interest they pay varies over time.
One such instrument is the floating-rate security. Floating-rate securities are typically issued by investment-grade companies with solid credit ratings.
They have interest rates that are tied to an index and reset pe- riodically. So if interest rates rise, floating-rate securities tend to pay a higher interest rate starting with the next reset date. The downside: floating-rate securities may offer yields lower than fixed-rate bonds of the same maturity offered by the same is- suer.
Bank loans are also variable rate investment vehicles, with rates that usually reset every 30, 60, or 90 days. These tend to offer a higher interest rate, but also may carry a greater credit risk than investment-grade floating-rate securities.
In a declining interest-rate environment, variable-rate instru- ments such as floating-rate securities and bank loans can be poor investment choices. However in stable and rising-rate en- vironments, they may offer a measure of protection against in- creasing interest rates. Discuss with your advisor whether vari- able-rate instruments are right for you, given your financial situation and investment goals.