How to rebalance your investment portfolio when bond prices fall

The recent broad selloff in world government bonds amidst anticipation that interest rates in major economies will remain high in the near future, has once again pushed bond volatility to an all-time high. If you are building an investment portfolio that comprises bonds, perhaps it is a good time to evaluate if you should rush to sell them off or put more money into investing in investment-grade bonds while prices are falling.

Factors that affect bond prices

Most investors view bonds as a relatively stable investment that complements their portfolio diversification strategy. However, factors like inflation, interest rates and market activity can pose risks associated with investing in bonds.

Inflation

When investors expect higher inflation in the future, they will demand higher yields to compensate for the decreased purchasing power of future bond payments. This leads to lower bond prices.

Taking the current economic climate as an example, inflation continues to linger with rising gas prices, sustained demand for some goods and services and geopolitical issues. As a result, investors are rushing to sell off their existing bonds because the falling bond prices are bringing in smaller interest payments and lower returns on their investment portfolio.

Interest rates

It is essential to understand that bond prices and interest rates have an inverse relationship. When interest rates rise, newly issued bonds offer higher yields, making existing bonds with lower interest rates less attractive. This naturally leads to falling bond prices. Conversely, when interest rates fall, existing bonds with higher fixed interest rates become more valuable, causing their prices to rise.

Investors who intend to hold their bonds until maturity have less need to worry about the movement of bond prices as they will be paid according to agreed terms. However, if your investment strategy favours selling your bonds at an earlier date for profit, you need to monitor fluctuation of bond prices and market interest rates more closely.

Market conditions

General market conditions can easily impact the demand for bonds and how the prices move. For example, when the stock market is rising, investors tend to go in favour of equities instead of bonds which leads to falling bond prices. When the stock market is going through a correction, bond prices tend to go up because investors may prefer fixed-income products for portfolio diversification since they are regarded as low-risk investments.

A surge in new bond issuances can also lead to falling bond prices. The sudden increase in supply means investors have more options to choose from and issuers have to offer higher yields with lower prices to attract buyers.

How to rebalance your investment portfolio when bond prices fall

Rebalancing your investment portfolio is a proactive approach to realigning your investment strategy and risk tolerance to ensure your portfolio is achieving your long-term financial goals in the face of changing market conditions. Typically, an investment portfolio may need to be rebalanced when certain assets in the portfolio outperform or underperform due to changes in market.

The first sign that you may need to rebalance your portfolio is when your asset allocations start to deviate from the initial plan. For example, your portfolio which comprised 80 per cent stocks and 20 per cent bonds has recently shifted to 85 per cent stocks and 15 per cent bonds allocations due to falling bond prices.

To regain balance, you may need to sell five per cent of your stock holdings and use the proceeds to invest in additional investment-grade bonds.

Do note that the rebalancing process may incur transaction costs or taxes that may impact your capital gains or losses. Be sure to weigh these costs before executing any trades to realign your portfolio. At the bottom line, your investment strategy should balance out the overall allocations together with the costs associated with them.

How to diversify a portfolio based on different risk tolerance

Portfolio diversification is one method of creating an investment portfolio comprising different asset classes from different industries and countries to minimise risk and optimise capital for higher returns. This strategy favours spreading risk as opposed to putting one’s eggs (investments) in one basket.

Even if you are not a risk-averse person, exercising prudence is still a must amidst this volatile market condition when everything can change in just a matter of days.

That said, if you are a light-weight investor who prefers to play it safe, the 60/40 strategy (60 per cent stocks and 40 per cent bonds) recommended by Javier Estrada, may offer decent upside potential and higher protection than more concentrated investment styles. Alternatively, a slight modification to 70/30 may also achieve similar results if the stocks and bonds are selected with due diligence.

For investors who do not mind taking higher risk, Warren Buffet’s 90/10 may appeal due to its simplicity and possibility for higher yield. Buffet's personal recommendation goes to putting 10 per cent of the cash in short-term government bonds and 90per cent in stock-based index funds.

However, do note that the bonds component which helps to reduce overall investment risks is very low. This means substantial research must be conducted during the selection of stocks to mitigate risks that may arise out of investing in stocks.

Remember that there are no guarantees of profits when you buy stocks. If Lehman Brothers could go under overnight, your best bet to selecting high-growth stocks should not be luck but meticulous research and fundamental analysis.

ALSO READ: 5 ways to diversify your investment portfolio

This article was first published in ValueChampion.