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Foundation Block #4 How does one maintain a Balanced Portfolio in a rising interest rate environment? or What does a Balanced Portfolio mean?

How does one maintain a Balanced Portfolio in a

rising interest rate environment?


What does a Balanced Portfolio mean?

My Point:  What about NOW?  We are now in a time of RISING interest rates.  What does that mean?  Well, let’s look at one more simplistic example on the effects of rising interest rates on a bond.

NOTE: this is extremely simplistic…bond pricing relies on a multitude of factors: length of time to maturity, quality of the issuer, the stated rate of return of the bond, and MANY other factors…so this is a VERY simple example.

Say that an investor has $1000 that needs to be returned as safely as possible at the end of a specified length of time—we’ll say 5 years. 

This person calls his financial advisor and his banker at the local branch and asks what the rates are for a 5-year bond (a CD, if it’s a bank.)

  • The CD yields 4.75%
  • a 5-year US Treasury yields 4.5%
  • a AAA rated bond yields 5%.

Why the differences?  Usually it has to do with the perceived credit quality of the underlying issuer.  Cd’s are backed by the FDIC, a Treasury bond is backed by the full faith and credit of the government, and AAA rating is reserved for companies of the highest quality.  [More on this subject in a later entry.]


To keep everything simple, I’m going to define the parameters:  the investment is exactly $1000, and to keep my math simple, I’ll choose the AAA-rated bond with the 5% stated rate.  The theory with bond investments is that one puts in $1000 and will receive $1000 back at maturity.

In this case, the Principal (P) is $1000; the Stated Rate (SR) (aka coupon rate) is 5%, which means the (IR) Interest Received is $50. 

Using simple math, we find that $50 (IR--interest received) divided by the maturity amount ($1000) = 5% (Y--yield)

Therefore, in this case, (Y) yield is the same as the (SR).

Interest Paid/Principal = Yield or stated in an equation:  IR/P = Y


Mathematically, we can solve for any of the elements when we know two of the other elements. 

Therefore: 1) $1000 (P) x 5% (.05) (SR) = $50 interest received (IR) each year

In our case above: $50 (interest paid) / $1000 (P) = 5% (Y)ield to Maturity

The key point here is that the starting ‘Principal’ and the ‘Stated Rate’ don’t change…a $1000 in and $1000 out…AT MATURITY, and a promise to 5% is just that…a promise…and one that is VERY serious…even on Wall Street.


BUT what happens as interest rates rise or fall?

Let’s use the same example as above but with different components—now the prevailing rates for a AAA-rated 5-year bond is now 6%—rates have gone UP.  

That’s great for NEW money being invested…but what if you own the 5% bond already…what’s its value as shown on your monthly statement (where everything is “Marked to the Market”)

Let’s go back to the simple math: we know the Stated Rate (SR) from above is 5%, which pays $50 (IR) (per $1000 originally invested), AND we know the NEW current yields are offered at 6%.

In this case, the math looks like:

SR / Y = P (or in this case, the CURRENT Principal value) à

$50 / 6% = $833…The bond VALUE has fallen.

If the current market rate is 4%, then a bond paying more than $40 per year is worth more.

$50 / 4% = $1250…the bond value has risen.

REMEMBER though, if held to maturity, you’ll have invested $1000 and you will receive $1000…so statement values are for reporting purposes, it’s not necessarily the ending results.

Herein lies the problem, in my earlier blog titled ”How does (or could) one Reduce the Risk in their Portfolio?” I went through how one might reduce portfolio risk…essentially, it comes down to adding a LESS risky asset to the MORE risky asset.

According to popular commentary, Stocks are considered MORE risky, and Bonds are the LESS risky asset class. 

So here’s the central problem as I see it…if interest rates are rising—and therefore the CURRENT value of bonds are falling—why would we even WANT to add a this LESS risky asset class to our stock portfolio.  It seems a losing proposition…


If you find this an interesting point, let’s talk about what to do to combat this phenomenon.


Disclosure:  This material contains forward looking statements and projections. There are no guarantees that these results will be achieved. It is our goal to help investors by identifying changing market conditions. However, investors should be aware that no investment advisor can accurately predict all of the changes that may occur in the market.

The views expressed are not necessarily the opinion of Royal Alliance and should not be construed directly or indirectly, as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Investing is subject to risks including loss of principal invested. This strategy cannot assure a profit nor protect against loss. Inherent limitations and market conditions may affect the performance of the portfolios. Past performance does not guarantee future results.

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