Investors have turned fearful of bonds and bond funds. The Federal Reserve is poised to raise rates this week for the third time in 15 months. The Fed itself and investors generally forecast least two more hikes this year. Why buy bonds now?
Bonds are the ultimate hedge on a stock portfolio. Given that stock valuations are stretched and optimism high, this is not the time to exit fixed income, but rather the time to pare back overexposure to equities and reinvest in fixed income.
Although bonds will be under pressure if rates move higher, rates typically move up due to a growing economy and or inflationary period. Those are the periods when stocks do well, so your equities help cushion your bond portfolio during periods of rising rates.
Interest rates are not as low as they first appear. True, they are low relative to the last 30 years. Today’s rates should not be evaluated solely against history but rather against current economic conditions. The key economic conditions driving interest rates are inflation and economic growth.
Both of those indicators are sluggish at best. Inflation has picked up a bit, but wage growth, the most important indicator, remains tepid. That’s why bond prices actually rose after February’s seemingly strong job numbers, because year over year wage growth was disappointing.
Further, our economy is far more dependent on overseas economic conditions than decades ago. Central banks are in no rush to match the Fed’s rate hikes because their outlook is so soft. That’s another reason to expect US economic growth to be muted, and with it lower interest rates than might otherwise be the case.
We are skeptical that anyone can regularly forecast the fluctuations in the bond market. Indeed, for the last seven years all the experts have warned us that rates were going higher. Taxable bond funds have returned 3% per year on average annually during that period.
If any institution had a crystal ball on rates, you’d think it would be the Federal Reserve. However, this is the same institution that Ben Bernanke admitted missed the sub-prime crisis in 2008. Last year, the Federal Reserve projected four rate hikes. We got one. Take the Fed’s forecasts with a big grain of salt.
The takeaway for investors is to prepare for rates to move up or down.
We think buying bonds with maturities of 10 years or less makes the most sense. The longer your maturity, the more sensitive to interest rates will be your fixed income.
A popular strategy is to ladder your bonds, meaning diversifying your purchases over the various maturities. This reduces risk and provides a continuing stream of income to reinvest as the shorter bonds come due. Still, the overall interest rate is less than simply buying ten year bonds.
We advise investors to stick to high quality bonds. If the point of bonds is to offset equity risk, you don’t want bonds that will weaken when stocks weaken. Credit challenged bonds, a/k/a junk, depend on a strong economy in order to pay off. Avoid those bonds in your fixed income portfolio or consider them part of your equity positions.
The point is made clear when looking at results from the last major downturn, in 2008. The S&P 500 dropped 37%, while the high quality Barclay’s Aggregate rose 5.2%, providing a nice offset to stocks. Investors who reached for yield by forsaking credit quality struggled; an index of high yield funds declined over 26%.
If you have a large enough portfolio, stick with individual bonds. With an individual bond, assuming the issuer honors its obligations, you know exactly your profit at the time of purchase, no matter where interest rates go. Admittedly, if you have to sell before maturity a rise in rates could hurt the price received. With individual bonds, you also avoid fund fees, all the more important in this low yield environment.
Unfortunately, bonds are less liquid than bond funds, and become very illiquid when very small purchases are made, say under $25,000 face value. Always keep a small portion of your fixed income in bond funds to provide for unforseen liquidity needs.
Note: David G. Dietze, JD, CFA, CFP™ is President and Chief Investment Strategist of Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Avenue, Summit.
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