Bond and Interest Rates - What to do?

The following illustration shows the relationship between bonds and interest rates. Think of it as a teeter totter. When one goes up the other goes down. Hence, when interest rates go down, bond prices will go up, and when interest rates go up, bond prices will go down.

Lower interest rates result in the appreciation of a bond mutual fund, but  also lower interest income payments over time. As bonds mature the new bonds purchased pay a lower interest rate. Thus, there are two main factors at work here for investors; the value of the investment and income provided. Consequently, I want to discuss both of these items and how they may impact you.  

Average Effective Duration

Regarding the first (value of investment), there is a term called duration, which is used as a measurement of how a bond fund's price will be impacted by interest rates changes. Average effective duration provides a measure of a bond fund’s interest-rate sensitivity. It is kind of like our thermometer in assessing how a bond fund will be affected by interest rate changes. 

The longer a fund’s duration, the more sensitive the fund is to shifts in interest rates. 

The relationship among funds with different durations is straightforward: A fund with duration of 10 years is expected to be twice as volatile as a fund with a five-year duration. 

Duration also gives an indication of how a fund’s net asset value (NAV), or what most of us refer to as price per share, will change as interest rates change. A fund with a five-year duration would be expected to lose 5% of its NAV if interest rates rose by 1 percentage point, or gain 5% if interest rates fell by 1 percentage point. 

Since we are probably facing higher interest rates going forward, duration is a measurement that we consider quite important. For that reason, we want to be selective and own funds that have lower average effective durations of say six or below versus funds with durations of say 15 or more. This is important because interest rates have begun creeping up. As a result, a fund with duration of 15 would see its net asset value (NAV) drop 15% or 2.5 times that of a fund with a duration of six. So in this regard, currently we are focusing on funds with what we consider lower average effective durations (AVEs). Ideally, we try and select funds with AVEs under four. I would rather have more downside protection against higher interest rates in the future, than reaching for more interest income today. 


As the prior illustration shows, interest rates and bonds have an inverse relationship. As a result, when you own a bond mutual fund, this can cause it to self-regulate. If interest rates go down over time, then you'll see your fund go up in value, but you'll also be receiving less income. On the other hand, if interest rates go up, then you see the price per share of your bond fund go down in value, but over time you'll start receiving more income. 

Hence, over a period of time (i.e., several years), bond funds will adjust for interest rate changes. The prospects of a lower price per share can be less painful when you begin to see a higher payouts. Thus, for investors needing income, higher interest rates aren't necessarily a horrible thing. It could sting at the beginning, but for those who can ride it out, more income will be a welcome change. Also, for those investors who are reinvesting their earnings, a higher income and lower price per share lets you reinvest and purchase more fund shares, which over time should provide you with greater income. Either way, more income may be in the offing.   

Common Factors Affecting Retirement Income 

When it comes to planning for your retirement income, it's easy to overlook some of the common factors that can affect how much you'll have available to spend. If you don't consider how your retirement income can be impacted by investment risk, inflation risk, catastrophic illness or long-term care, and taxes, you may not be able to enjoy the retirement you envision. 

Investment risk 

Different types of investments carry with them different risks. Sound retirement income planning involves understanding these risks and how they can influence your available income in retirement. 

Investment or market risk is the risk that fluctuations in the securities market may result in the reduction and/or depletion of the value of your retirement savings. If you need to withdraw from your investments to supplement your retirement income, two important factors in determining how long your investments will last are the amount of the withdrawals you take and the growth and/or earnings your investments experience. You might base the anticipated rate of return of your investments on the presumption that market fluctuations will average out over time, and estimate how long your savings will last based on an anticipated, average rate of return.

Unfortunately, the market doesn't always generate positive returns. Sometimes there are periods lasting for a few years or longer when the market provides negative returns. During these periods, constant withdrawals from your savings combined with prolonged negative market returns can result in the depletion of your savings far sooner than planned. 

Reinvestment risk is the risk that proceeds available for reinvestment must be reinvested at an interest rate that's lower than the rate of the instrument that generated the proceeds. This could mean that you have to reinvest at a lower rate of return, or take on additional risk to achieve the same level of return. This type of risk is often associated with fixed interest savings instruments such as bonds or bank certificates of deposit. When the instrument matures, comparable instruments may not be paying the same return or a better return as the matured investment. 

Interest rate risk occurs when interest rates rise and the prices of some existing investments drop. For example, during periods of rising interest rates, newer bond issues will likely yield higher coupon rates than older bonds issued during periods of lower interest rates, thus decreasing the market value of the older bonds. You also might see the market value of some stocks and mutual funds drop due to interest rate hikes because some investors will shift their money from these stocks and mutual funds to lower-risk fixed investments paying higher interest rates compared to prior years. 

Inflation risk 

Inflation is the risk that the purchasing power of a dollar will decline over time, due to the rising cost of goods and services. If inflation runs at its historical long term average of about 3%, the purchasing power of a given sum of money will be cut in half in 23 years. If it jumps to 4%, the purchasing power is cut in half in 18 years.

A simple example illustrates the impact of inflation on retirement income. Assuming a consistent annual inflation rate of 3%, and excluding taxes and investment returns in general, if $50,000 satisfies your retirement income needs this year, you'll need $51,500 of income next year to meet the same income needs. In 10 years, you'll need about $67,195 to equal the purchasing power of $50,000 this year. Therefore, to outpace inflation, you should try to have some strategy in place that allows your income stream to grow throughout retirement. 

(The following hypothetical example is for illustrative purposes only and assumes a 3% annual rate of inflation without considering taxes. It does not reflect the performance of any particular investment.) 

Equivalent Purchasing Power of $50,000 at 3% Inflation                  


Long-term care expenses 

Long-term care may be needed when physical or mental disabilities impair your capacity to perform everyday basic tasks. As life expectancies increase, so does the potential need for long-term care. 

Paying for long-term care can have a significant impact on retirement income and savings, especially for the healthy spouse. While not everyone needs long-term care during their lives, ignoring the possibility of such care and failing to plan for it can leave you or your spouse with little or no income or savings if such care is needed. Even if you decide to buy long-term care insurance, don't forget to factor the premium cost into your retirement income needs. 

The costs of catastrophic care 

As the number of employers providing retirement health-care benefits dwindles and the cost of medical care continues to spiral upward, planning for catastrophic health-care costs in retirement is becoming more important. If you recently retired from a job that provided health insurance, you may not fully appreciate how much health care really costs. 

Despite the availability of Medicare coverage, you'll likely have to pay for additional health-related expenses out-of-pocket. You may have to pay the rising premium costs of Medicare optional Part B coverage (which helps pay for outpatient services) and/or Part D prescription drug coverage. You may also want to buy supplemental Medigap insurance, which is used to pay Medicare deductibles and co-payments and to provide protection against catastrophic expenses that either exceed Medicare benefits or are not covered by Medicare at all. Otherwise, you may need to cover Medicare deductibles, co-payments, and other costs out-of-pocket. 


The effect of taxes on your retirement savings and income is an often overlooked but significant aspect of retirement income planning. Taxes can eat into your income, significantly reducing the amount you have available to spend in retirement. 

It's important to understand how your investments are taxed. Some income, like interest, is taxed at ordinary income tax rates. Other income, like long-term capital gains and qualifying dividends, currently benefit from special--generally lower--maximum tax rates. Some specific investments, like certain municipal bonds, generate income that is exempt from federal income tax altogether. You should understand how the income generated by your investments is taxed, so that you can factor the tax into your overall projection. 

Taxes can impact your available retirement income, especially if a significant portion of your savings and/or income comes from tax-qualified accounts such as pensions, 401(k)s, and traditional IRAs, since most, if not all, of the income from these accounts is subject to income taxes. Understanding the tax consequences of these investments is vital when making retirement income projections. 

Have you planned for these factors? 

When planning for your retirement, consider these common factors that can affect your income and savings. While many of these same issues can affect your income during your working years, you may not notice their influence because you're not depending on your savings as a major source of income. However, investment risk, inflation, taxes, and health-related expenses can greatly affect your retirement income.


Ten Hot, Dirty And Long Days, But Worth It! 

My oldest son, Jake, just finished his 10-day stay at the H Roe Bartle Scout Camp near Oseolo, MO.


It was hot, dirty and quite tiring, but he had a great time and earned several merit badges. I am proud of and happy for him at the same time. 

Scouts was not something that was readily available to me as a kid. However, I have been quite amazed at how Jake (going into 7th grade) can hang with the older high school boys, while being quite comfortable in his own skin. In addition, he is learning great leadership skills. Along that line, I find it quite ironic that at home he may struggle getting a chore done, but at camp he is quite capable and goes right after it. Maybe it is balance between a sense of pride and accomplishment versus peer pressure. Whatever it is; it's working. 

I have gone several campouts with him, and I have been thoroughly impressed with the kids and the other dads. My hope is that he can continue to take on the various challenges they present him and shoulder more responsibility within the troop. I believe this is important since many of today's youths are not motivated and will struggle with real life situations, especially in the workplace, if they've not been tested and had leadership opportunities. 

In the near term, a shower, laundry and a nap are all that are on his agenda. 


"When all else fails, say exactly how you feel."      

                   Danyel Smith 

"Mastering one's future must surely start with managing one's self."

                   Shad Helmstetter 

"When prosperity comes, do not use all of it."



Tony Moeller, CPA 

The information listed in this commentary is a compilation of various publicly available sources and is for informational purposes only. It is not a recommendation or solicitation of any particular investment or strategy. A risk of loss is involved with investments in the stock and bond markets.  

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