Bond yields have fallen dramatically since the 2008 credit crisis, driven largely by the quantitative easing policy of the Federal Reserve. The Fed has stated its intent to begin cutting back monthly purchases of securities which peaked at $85B a month. Rates may be poised to rise, signaling the possibility of a decline in bond prices.
Before panicking about the potential for sub-par market returns, note that a bear market for bonds is usually relatively tame versus what transpires in the equity markets. 2013 was considered an underperforming year, but total return for the Barclay’s Aggregate Index fell just -2.0%. The historically worst twelve-month return for bond investors was back in 1974, when the index fell -13.9%. This is clearly not the same as what investors experience in the equity markets, where a classic bear market is defined as a price decline of 20%.
Keep your eye on what bonds deliver – diversification, stability, and a steady income stream. Bonds have been traditionally less volatile than equity markets, allowing you the comfort of sleeping more soundly at night. Make sure your bond allocation is where you want it. Rebalance, make changes to your target allocation, do what suits your investment horizon and lifestyle. So what are some options for avoiding the pain of a potential rise in interest rates?
Keep it short – Duration is the measure of a bond’s price movement in response to a change in rates. Figured in the calculation is the time to maturity and the time it takes for a holder to receive all payments from a bond. A shorter duration generally equates with less interest rate risk and more protection to principal. All else being equal, bonds with a shorter maturity and higher coupon generally have shorter durations. Floating rate bonds, which reset interest payments frequently, will also have shorter duration. You can protect your portfolio by creating shorter duration through purchases of shorter maturity, higher coupon, or floating rate issues. However, a shorter duration strategy often results in lower yields and income streams, which may be a problem if you need current income to keep up with inflation.
Diversify and take on incremental credit risk – within reason – A diversified fixed income portfolio may perform better than one positioned exclusively in U.S. Treasuries. Historically, corporate and higher yielding bonds tend to bear the brunt of rising rates better, mostly due to their spreads versus Treasuries narrowing in the face of an improving economy. However, high yield bond spreads are now at historic lows, implying investors may not be picking up enough yield to compensate for credit risk. We continue to advocate high quality corporate bonds and select municipals as sound additions to any portfolio.
Active management offers advantages vs indexing - Public debt issuance has crowded out that of private debt over the past few years. The Treasury component of the Barclay’s U.S. Aggregate Bond Index grew from 25% in 2006 to over 36% in 2012, with corporate debt increasing at a much smaller rate. Index funds have become heavily weighted with Treasuries. An actively managed portfolio will offer investors the opportunity to seek out non-Treasury issues with shorter duration and more credit upside.
Ladder your holdings – For those investors who can buy and hold, purchasing securities that mature in sequential years offers protection. As one bond comes due, the proceeds from this lower rung of the ladder can be reinvested in a longer-maturity, higher rung, likely with a larger coupon as rates rise. This provides a greater income stream to buffer price erosion.
Although investors may be tempted to bail on the bond market given recent Fed policy, staying the course and selectively choosing your fixed income investments is the prudent action. You will be rewarded with the diversification and stable income stream fixed income can provide, while circumventing some of the more interest-rate sensitive sectors of the market.
Note: Elaine Phipps, MBA, CFA is a Portfolio Manager at Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Avenue, Summit. CNBC has named Point View number 5 on its list of the top 100 American fee-only wealth managers. See http://www.cnbc.com/id/101619698. The full-length version of this article is available at: www.ptview.com.