As we near the midpoint of 2015, many bond investors are wondering what their strategy should be for the rest of the year. After all, it is widely understood that the Federal Reserve will increase interest rates sometime in the relatively near future — if not soon, then probably before the end of the year.
Rising interest rates will have a significant impact on bond investing. When rates rise, bond prices decline, which lowers the value of existing bonds that were bought when rates were lower. Therefore, bond investors are keeping a close watch on what might happen with interest rates between now and the end of the year.
Given the imminent interest rate hike by the Fed, what is the best strategy for bond investors right now? Here are four things to keep in mind as you consider this question:
- Remember the role of bonds in an investment portfolio. Bonds should serve two main functions in the typical investors’ portfolio: 1) Provide income, and 2) help insulate the portfolio against potentially volatile equities.
Granted, bonds have not provided much income in recent years since interest rates have been so low. Two-year Treasury bonds are currently yielding around 0.6%, while yields are a little higher on longer-term Treasuries: 1.5% on five-year Treasuries, 2.2% on ten-year Treasuries and 2.7% on twenty-year Treasuries. Higher yields can be obtained on lower-quality bonds, but these entail higher risk as well.
However, you must remember that the main purpose of bonds for most investors is not to generate high income — it is to serve as a shock absorber to protect against the potentially volatile stock side of the portfolio. With the appropriate balance of bonds in your portfolio, based on your risk tolerance and time horizon, it will be easier for you to ride out periods of stock market volatility, since the bonds will help stabilize the portfolio as a whole.
- Keep bond market volatility in perspective. Some pundits have been fretting about what they say is an upcoming “Bondmageddon” when interest rates finally start rising. However, even at its worst, bond market volatility is nothing when compared to stock market volatility.
The biggest one-year drop in the Global Financial Data extension of Moody’s monthly total return index for thirty-year corporate bonds was 12.5% in 1980. Now compare this to the biggest one-year drop in the stock market: a loss of 67.8% in the S&P 500 in 1932. Moreover, since 1900, one-year losses in the S&P 500 have exceeded 12.5% (the biggest annual bond market loss) 23 different times.
- Consider factors other than interest rates that affect bond investing. Many factors in addition to interest rates affect bond investing. Consider liquidity, for example: Bond market liquidity has been decreasing since banking regulations adopted after the financial crisis in 2008 started requiring banks to tighten up their balance sheets. This has forced banks to reduce their trading volume, which reduces liquidity. This, in turn, increases the impact that each bond purchase or sale can have on bond prices.
Maturities and credit quality are two other factors affecting bond prices. Unlike interest rates, you actually have control over these elements. Keeping maturities short will give you more flexibility to make adjustments in your bond holdings when rates do finally start rising, while staying focused on Treasuries and highly rated corporate bonds will keep your credit risk to a minimum.
- Look at non-U.S. bonds as a fixed-income investing alternative. One way to increase bond yields is to look beyond our shores at international bonds. In fact, non-U.S. bonds are the world’s largest asset class, according to a report published by the Vanguard Group.
Some experts suggest allocating up to twenty percent of a fixed-income portfolio to overseas bonds. You can choose from international bonds in both developed and emerging market nations. Keep in mind, however, that currency risk comes into play when investing in international bonds due to fluctuating exchange rates. The best way to deal with this risk is to invest in mutual funds that currency hedge for international bond holdings.
There is no sugar coating the fact that bonds and bond funds will be negatively impacted when interest rates eventually go up. However, this does not necessarily mean that you should dump all your bonds right now and stay away from bonds for the foreseeable future.
For one thing, if you own a diversified portfolio with high-quality bonds, your returns will likely rise later when the fund reinvests interest payments in new bonds that pay higher rates. If you are investing for retirement or other long-term goals, you might consider investing in a total U.S. bond market index fund or ETF that includes a mix of Treasury, mortgaged-backed, high-grade corporate and government agency bonds.
Most importantly, however, always remember the first point above. Bonds should play a very specific and integral part in most investors’ portfolios. This fact does not change regardless of which direction interest rates move.