How rising interest rates affect bond investments—and what you should do about it

Even if the college years are a long way off for your family, your 529 portfolio may include an allocation to bonds. That's because bonds can be a great investment if you're looking to balance the volatility of stocks in your portfolio and lower your overall risk of loss. But what happens if bonds fail to produce a positive return?

Bond investors may find themselves in this very situation when interest rates rise. Why? Well, bonds have what's called interest rate risk—so when rates rise the prices of any bonds you currently own in your portfolio fall. As a result, you'll see your principal investment fall. As someone saving for higher education, what should you do?

If you have a balanced stock/bond portfolio

First, take a deep breath and remember why you invested in both stocks and bonds in the first place. Stocks and bonds aren't supposed to move in lockstep; if bonds rise when stocks rise, then chances are that both pieces of your portfolio will turn negative at the same time too. The reason that diversifying your portfolio lowers your overall risk is that gains in one area can help to offset losses in another.

You may have noticed an example of this last year. From January through September 2013, when the overall bond market dropped nearly 2%, the overall stock market was up more than 21%.* So any portfolio diversified with stocks—even a conservative one—likely had a flat or positive return.

If you invest solely in bonds

A downturn in bonds can be especially painful for conservative investors—those who are most risk-averse are also the investors hardest hit by negative returns.

In this case, you'll want to step back and consider your risk tolerance, which led you to choose an all-bond portfolio (or a moderate to conservative age-based portfolio). Investing in bonds doesn't guarantee that your returns will always be positive, but it does lessen the big swings in value that can occur with an all-stock portfolio. And in fact, bond market returns for the previous 5 calendar years ranged from a sedate low of about 4% to around 8%.*

That said, if you feel nervous about what bond losses might do to your child's college dreams, remember that in the past, even the worst downturn in bonds didn't come close to a bad bear market in stocks.

Think hard before you act

Whether you have a little bit of your portfolio invested in bonds or a lot, you may be tempted to make up for any losses by moving your money into stocks. But that could leave you even worse off if stocks begin to fall.

On the other hand, if even bonds seem too risky at this point, you might feel more comfortable in a cash investment. Some investors only realize their true tolerance for risk when things get rough. Keep in mind, however, that this move makes more sense if your child is close to (or currently in) college. Investors with younger children have more time to wait out a downturn.

As you think about making any changes, we encourage you to choose your allocation based on the things you know for sure: your risk tolerance and your timeline. If you're a conservative investor, you may feel some short-term pain right now. But remember what your allocation to bonds provides you--a cushion from the more-serious losses that could follow from a bear market in stocks.

*Return figures for bonds are derived from the Barclays US Aggregate Bond Index. Figures for stocks are derived from the Dow Jones US Total Stock Market Float-Adjusted Index.

Notes:

All investing is subject to risk, including the possible loss of the money you invest. Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline. In a diversified portfolio, gains from some investments may help offset losses from others. However, diversification does not ensure a profit or protect against a loss.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.