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Stocks or Bonds: What Happens When Rates Rise?

Understanding income-producing investments—and how they might behave as interest rates rise—can help guide your search for income.

ALTHOUGH THERE ARE NO SPECIFIC RULES about how bonds and dividend-paying stocks respond to rising interest rates, there are some broad tendencies you may want to consider.

"It's important to consider the risks and potential rewards of a variety of assets and take an approach that emphasizes total return." — Karin Kimbrough, head of Macro and Economic Policy at Merrill Lynch Wealth Management

With bonds, the "coupon rate" is the interest rate that an issuer uses to calculate regular interest payments to investors. The longer the term of a bond, the higher the coupon is likely to be; you're paid more to wait longer to get your principal back. Higher risk, too, affects the coupon, with high-yield bonds from less solid companies offering more generous interest payments than you'll get from higher-rated corporations or from U.S. Treasury bonds.

While coupon rates don't change during the life of a bond, bond prices themselves do fluctuate as bonds are bought and sold on secondary markets. And changes in prevailing interest rates will affect the value of bonds in your portfolio. If rates are on the rise, newly issued bonds with higher rates will be more appealing than older bonds paying less. That can reduce demand for your existing bonds and push down their resale prices. When rates are rising, bonds with longer maturities tend to suffer most because they lock investors into lower rates for extended periods.

Meanwhile, dividend stocks are less directly affected when interest rates rise, which has historically happened when the economy is growing. But the kinds of companies that thrive during an economic expansion are also the ones most likely to increase their dividends. There isn't a single strategy that will work for everyone. "It's important to consider the risks and potential rewards of a variety of assets and take an approach that emphasizes total return," notes Karin Kimbrough, head of Macro and Economic Policy at Merrill Lynch Wealth Management.

3 Questions to Ask Your Advisor

  1. Should I consider adding more dividend-paying stocks to my portfolio?
  2. How could a potential rise in interest rates affect the bonds I'm holding?
  3. Are there ways I could be adjusting my portfolio to provide greater yield?

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Investments in high-yield bonds (sometimes referred to as “junk bonds”) offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a junk bond issuer’s ability to make principal and interest payments.

Income from investing in municipal bonds is generally exempt from Federal and state taxes for residents of the issuing state. While the interest income is tax-exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the Federal alternative minimum tax (AMT).

Companies may reduce or eliminate dividends to shareholders. Historically, dividends make up a larger percentage of a stock’s total return.

This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. The investments discussed have varying degrees of risk. Some of the risks involved with equities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U.S. or abroad. All sector and asset allocation recommendations must be considered by each individual investor to determine if the sector is suitable for their own portfolio based upon their own goals, time horizon, and risk tolerances.

Investing in fixed income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa.

Investments focused in a certain industry may pose additional risks due to lack of diversification, industry volatility, economic turmoil, susceptibility to economic, political or regulatory risks, and other sector concentration risks. 

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