If you’re like many people, you may pay a lot of attention to the day-to-day price movements of your investments. But to create and maintain an effective investment strategy, you also need to look at the “big picture” — specifically, the economic and market forces that can affect your investments’ performance. And one of those factors is inflation.
Of course, inflation has been fairly tame lately. In fact, some consumer prices fell through much of 2009, according to the Bureau of Labor Statistics. Will the mild inflation environment continue?
It’s risky to try to predict the course of any economic development. Yet some key signs point to continued low inflation. For one thing, unemployment remains stubbornly high. Fewer people working means fewer people spending, which lowers the demand for goods and services. Also, we are currently not producing anywhere near as much as we could, given our productive capacity, according to the Federal Reserve (Fed). When this gap exists, the economy can typically expand without triggering higher inflation.
If inflation does remain low for the near term, the Fed is unlikely to raise short-term interest rates significantly; it typically raises rates in an effort to “cool down” an overheated economy. Consequently, if inflation stays low, you may be looking at continued low interest rates, at least for a while. This would affect all types of investments, but it’s especially relevant to fixed-income vehicles, such as bonds.
Assuming short-term rates stay low for a while, what opportunities should you consider for your bonds? For one thing, you may want to expand your holdings beyond short-term bonds; longer-term bonds usually offer higher interest rates as compensation for inflation risk, which increases over time.
If interest rates do rise, however, the value of existing bonds tends to fall; no one will pay you the face value of your bond when newer ones are issued at higher rates. But because they have a long future stream of interest payments that wouldn’t keep up with current rates, long-term bonds typically adjust more than short-term ones.
If it’s suitable for your investment objectives, risk tolerance and financial circumstances, a bond ladder may help you prepare for changes in inflation and interest rates. And by being prepared, you can avoid negative behaviors, such as hasty decisions and excessive trading, while you position your portfolio to help achieve your long-term goals.
Systematic investing does not guarantee a profit or protect against loss. This article was written by Edward Jones for use by your local Edward Jones Financial Advisor.
Short /Radio version:
ANNCR: Inflation has been pretty tame lately. If this continues, how will it affect your investments, particularly your bonds?
If inflation does remain low for the near term, the Federal Reserve is unlikely to raise short-term interest rates significantly. Assuming short-term rates stay low for a while, you may want to consider longer-term bonds, which usually offer higher interest rates, if suitable for your goals, risk tolerance and time horizon.
But if interest rates rise, the value of existing bonds tends to fall and if sold prior to maturity, the investor can lose principal value. To help protect yourself against this interest-rate risk, consider building a “ladder” containing bonds of varying maturities. When rates rise, you may be able to reinvest the proceeds of your short-term bonds in new ones that carry the higher rates. And if rates fall, you can still collect larger interest payments from your longer-term bonds. In addition to interest rates, credit quality and risk are also important considerations when selecting bonds.
By keeping inflation and interest rates in mind, you can help build an “all-season” bond portfolio.
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