In the dis­cus­sion on ris­ing in­ter­est rates, the re­al ques­tion isn't if they will rise, it is when. Giv­en this re­al­i­ty, it is worth­while to eval­u­ate the risk of own­ing bond mu­tu­al funds ver­sus in­di­vid­ual bonds in a ris­ing in­ter­est rate en­vi­ron­ment.

One ba­sic prin­ci­ple of bonds is that when in­ter­est rates rise, the val­ue of in­di­vid­ual bonds typ­i­cal­ly de­clines. Here's a sim­pli­fied ex­am­ple to il­lus­trate why. Let's say a bond ma­tur­ing in five years is cur­rent­ly pay­ing a coupon of 3 per cent. Hy­po­thet­i­cal­ly, if in­ter­est rates rise, new­ly is­sued five-year bonds may pay 3.5 per cent in­ter­est.

Since these new­ly is­sued bonds are pay­ing more in­come, the bonds would sell for less than the new­ly is­sued bond pay­ing the high­er in­ter­est. No one is go­ing to pay the same price for bonds that pay less in­ter­est. The val­ue of the bond de­clined as in­ter­est rates rose.

Though the val­ue of bonds can move up and down, it is less of an is­sue of whether the bond is held to ma­tu­ri­ty. If a bond is held to ma­tu­ri­ty, the bond will con­tin­ue to pay the stat­ed in­ter­est and will ma­ture at full val­ue. If, how­ev­er, one wish­es to sell the bond when in­ter­est rates rise, they may find the val­ue of the bond has de­clined. As long as in­di­vid­ual bonds are held to ma­tu­ri­ty, the in­vestor knows ex­act­ly what they will get and when. This is where the eval­u­a­tion of own­ing in­di­vid­ual bonds ver­sus bond funds comes in­to fo­cus.

In bond funds, there can be hun­dreds, if not thou­sands of bonds in the port­fo­lio. An in­vestor buys in­to the bond fund at the Net As­set Val­ue, or NAV, of the fund and owns a slice of the port­fo­lio of bonds. As in­ter­est rates rise, and if the port­fo­lio man­ag­er con­tin­ues to keep the same bonds in the port­fo­lio, the val­ue of the bonds in the port­fo­lio will de­cline, as will the NAV.

If the in­vestor wants to liq­ui­date the po­si­tion in the bond fund, the amount re­ceived may be less than was orig­i­nal­ly in­vest­ed. In ad­di­tion, the NAV can be ad­verse­ly im­pact­ed if the bond fund man­ag­er has to sell bonds for less than they were pur­chased for as a re­sult of hav­ing to raise cash to cov­er re­demp­tion re­quests.

So, how can you pro­tect your­self?

When in­vest­ing in bond funds in a ris­ing in­ter­est rate en­vi­ron­ment, con­sid­er bond funds that in­vest in bonds with short­er ma­tu­ri­ties. Short­er-term bonds will gen­er­al­ly be less volatile than longer-term bonds when in­ter­est rates rise. If in­ter­est rates are ris­ing as those short­er-term bonds ma­ture, the pro­ceeds can be rein­vest­ed in­to bonds pay­ing a high­er in­ter­est rate. With longer ma­tu­ri­ty bonds, one is locked in for a longer pe­ri­od of time, and this can make those bonds more volatile in a ris­ing rate sit­u­a­tion.

An­oth­er op­tion is to con­sid­er buy­ing high cred­it qual­i­ty in­di­vid­ual bonds in­stead of bond funds and hold­ing those bonds to ma­tu­ri­ty. You will re­ceive the stat­ed in­ter­est rate and the full val­ue at the bond's ma­tu­ri­ty, thus avoid­ing the prob­lem of the de­crease in val­ue of the bond dur­ing the in­ter­im if in­ter­est rates rise.

Last­ly, con­sid­er lad­der­ing in­di­vid­ual bonds over a pe­ri­od of years. This means build­ing an in­di­vid­ual bond port­fo­lio with bonds of var­i­ous ma­tu­ri­ty dates. This tends to help pro­tect an in­vestor in both ris­ing and falling in­ter­est rate en­vi­ron­ments.

For ex­am­ple, if an in­di­vid­ual port­fo­lio is com­prised of 10 bonds, each with a ma­tu­ri­ty from one to 10 years, as each bond ma­tures it is rein­vest­ed in a bond ma­tur­ing in 10 years. Re­gard­less of whether in­ter­est rates are go­ing up or go­ing down, as each bond ma­tures a new 10-year bond is pur­chased.

This strat­e­gy tends to smooth out the ef­fects of bond rates ei­ther ris­ing or falling, since each year a new 10-year bond is bought at the pre­vail­ing cur­rent in­ter­est rates. So, if in­ter­est rates rise, each year a bond will ma­ture that can then be rein­vest­ed in a bond pay­ing a high­er in­ter­est. On the oth­er hand, if rates fall, on­ly one bond is ma­tur­ing that will have to be in­vest­ed at the low­er in­ter­est rate. The rest of the bonds are still pay­ing the high­er in­ter­est Source: US News and World Re­port