Rising Interest Rates May Hurt your 401(k)

Everyone is probably aware that we have historically low interest rates. The low rate environment affects not only what you pay for a new mortgage or car loan, but also affects the returns provided by bonds. Most 401(k) investors have a portion of their portfolio invested either in bonds, or target date funds which includes bonds as part of the portfolio. Those investments have done well over the last few years as I’ll explain below.

The reason we have low rates worldwide is the result actions by Central Banks – in the US, it is known as the Federal Reserve (Fed). In an effort to stimulate the economy, the Fed lowered rates to encourage borrowing and growth. The Central Bank in many other developed countries, have lowered their rates so low that they now pay a negative rate of interest on the bonds issued by their government.

The Fed raises interest rates from time-to-time to curb inflation and prevent runaway inflation. It has been a frequent news item that the Fed has been considering raising interest rates for some time now. Many feel that that won’t happen in November, but could well happen in December.

The reason that bonds have been good investments over the last several years is that the value of bonds and interest rates have an inverse relationship. In other words, when interest rates go down, the value of bonds typically goes up. So, as interest rates have fallen to record lows over the last several years, the value of bonds in your 401(k) have gone up – and nicely!

Conversely, when interest rates go up, the value of bonds typically go down. So the gains you have achieved through the rising value of bonds over the last several years could well disappear over the next several weeks or months as interest rates are increased.

Bonds are commonly thought of as being safer than investing in stocks. While it’s true that bonds have less volatility than the stock market, one shouldn’t think that they can’t lose money by having bonds in their portfolio.

A poll by Wells Fargo and Gallup reveals that most investors do not understand the impact of rising interest rates.  http://www.gallup.com/poll/183812/investors-anxious-hopeful-interest-rates.aspx.  Take a look at the chart below and see for yourself how bond prices can fall and the effect that can have on your portfolio.


Bonds are not immune to loss. You should review your 401(k) and determine the risk of having bonds as part of your portfolio. A bond measurement known as duration provides an indication of how a rise in interest rates will affect the value of a bond holding. If you are not familiar with these concepts, I would encourage you to visit with a financial advisor.