What the Fed’s lower rates mean for bond investors — and how to invest now

Investors who’ve held onto long-term bonds over the past few years might finally have their chance at seeing gains in a lower interest rate environment. Rate cuts by the Federal Reserve could push long-term bond prices higher after a period of declining values.

However, as exciting as falling rates may seem, it’s important to maintain a diversified portfolio. Unexpected events — from economic shocks to potentially higher inflation — can disrupt bond performance. 

Here’s a look at how lower rates from the Fed affect bond investors.

Monetary policy — specifically, actions by the Fed to tame inflation or stimulate economic growth — has a direct influence on interest rates and, therefore, bond prices.

When interest rates rise, bond prices tend to fall. This happens because new bonds are issued with higher interest payments, making them more attractive than existing bonds that have lower payouts.

On the flip side, when interest rates fall, as they’ve been doing lately, bond prices rise. Older bonds that offer higher interest payments become more valuable because they provide better returns than newly issued bonds with lower interest rates.

4 tips for investing in a lower-rate environment

So how do lower rates from the Fed impact bond investors? First off, each investor’s individual goals, timeline and risk tolerance will differ. That means investing in bonds might look different for everyone. 

While a lower-rate environment means potentially higher gains for longer-term bonds, each investor should keep in mind their individual strategy and aim to be as diverse as possible when it comes to asset allocation to offset any potential losses.

That said, here are four ways you can adjust your portfolio given a lower-rate environment.

1. Adjust bond allocations based on duration

In a lower-rate environment, long-term bonds benefit the most because they lock in higher yields over time. Consider rethinking the role longer-term bonds play in your portfolio and potentially increase your exposure.

Be aware, though, that while long-term bonds seem more attractive, their yields may have already decreased significantly in anticipation of lower prevailing rates, so you might not see much more of a price increase.

The goal should essentially be to secure a stable income, rather than expect significant capital gains from further price increases.

2. Balance government and corporate bond exposure

Lower rates reduce yields on government bonds, which tend to be lower-yielding securities to begin with. So investors may decide to shift more of their money to higher-yield corporate bonds. While this higher income can be appealing, corporate bonds also come with more credit risk associated with the issuer. It’s essential to balance your bond portfolio exposure between stable government bonds and corporate bonds.

3. Position your portfolio for stability

Lower interest rates increase the demand for bonds, but don’t overlook the stability that bonds provide, too. Focus on maintaining liquidity to avoid potential cash crunches, rather than solely seeking higher yields.

A bond ladder or CD ladder can offer you some liquidity — regular interest payments — and a predictable cash flow, which can help you avoid the need to sell due to a cash crunch.

Bond ladders allow investors to spread out bond maturities, providing both regular income and protection against interest rate changes. The idea is that parts of the portfolio mature at different intervals and the interest income can be reinvested.

Overall, it’s important to build a portfolio that balances income with the preservation of capital.

4. Maintain overall diversification

The importance of diversification in a portfolio can’t be emphasized enough. Some bonds may be more attractive in times of lower interest rates, but consider the role that bonds play within your portfolio overall: that is, they reduce the volatility of a portfolio otherwise tilted heavily toward stocks and other higher-risk assets.

That’s not to say equities and alternative investments don’t have their place. Make sure your asset allocation reflects a solid mix of investments that can handle various market environments, protecting you from overexposure to any one type of investment.

Bottom line

Long-term bonds and some corporate bonds may become more attractive if interest rates continue to fall. As market demand shifts from shorter-term bonds to longer-term debt instruments, the key is maintaining a diversified portfolio. Every individual investor’s goals will differ, but generally steer clear of chasing higher yields and aim to meet your liquidity needs first. Balance your portfolio with a mix of investments that can weather multiple economic conditions.

— Daily Tech Finance’s Brian Baker contributed to an update of this article.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.