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By Christine Benz and Eric Jacobson | 01-27-2016 04:00 PM

Rising Rates and Your Bond Portfolio

Determining how your portfolio will respond to rate movements is far from an exact science, but investors should be mindful of why they're holding bonds in the first place, says Morningstar's Eric Jacobson.

Christine Benz: Hi, I'm Christine Benz for How do the Fed's actions affect your bond portfolio? Joining me to discuss that question is Morningstar senior analyst Eric Jacobson.

Eric, thank you so much for being here.

Eric Jacobson: Good to be with you, Christine. Thank you.

Benz: Eric, let's discuss what's in the Fed's tool kit and what isn't. When we hear the Fed is going to begin raising rates, we're talking about short-term rates, right?

Jacobson: That's right. They do have some tools that can impact longer-term yields, and they have used them in the last several years; but really the focus, generally speaking, is on short-term rates--and in particular, the one that we call fed funds, which involves the price of money that banks earn when they deposit money at the Fed. It's basically like a transmission tool to affect things in the rest of the economy. It's transmitted through the banking system.

Benz: So, if I have intermediate- or maybe even longer-term bonds or some sort of bond fund in my portfolio, how should I expect to see that fund react in a period in which the Fed is raising rates?

Jacobson: Unfortunately, there is no good formula that you can just plug in and say, "If the Fed does this, my portfolio is going to do that." You would hope or think that maybe knowing the duration of your portfolio might help you with that. The problem is that that number tells you about how things are going to react to changes in rates of longer maturities or maturities that are similar to those in your portfolio; because the fed funds' rate is very, very short term, it doesn't necessarily transmit one-to-one with everything else going on at longer maturities. What it does do, however, is it affects the price of borrowing money at that short level. And because the Fed can ratchet it up or lower it down and because a lot of parts of the economy do depend on borrowing levels there, it can ripple through the rest of the bond market and the economy by changing expectations for what's going to happen in the future.

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