2016’s final days left bond investors unsettled.
Just a few months ago, with the backdrop of the surprise July Brexit vote, U.S. Treasury yields hit record lows. Donald Trump’s election as president has increased concerns of a new round of tax cuts and greater government spending, which could stimulate inflation. The Federal Reserve has finally raised interest rates and is signaling more rate hikes are to come. In light of the ensuing bond market volatility, investors are wondering if fixed income still makes sense.
Rising bond yields and inflation usually mean diminishing returns for the fixed income asset class. However, we do not recommend investors shun the asset class, as bonds are an integral part of your portfolio. Here is what to keep in mind:
Should I Avoid Bonds? The answer is a definitive no. Bonds provide solid diversification from stocks, less volatility than many other asset classes, and a steady income stream. Individual bonds, barring default, guarantee a lump sum payment if held to maturity.
Even in a rising rate environment, bonds can still offer benefits. Investors perceive them as offering a safe haven, and therefore they often rally during stock market volatility, whether due to terrorism, natural disasters, political crisis or other unforeseen events.
Rising Rates Mean Falling Bond Prices, So How Can I Make Money? Rising rates, while reducing a bond’s principal value initially, often stabilize over time. Yet, payouts remain constant, resulting in higher yields based on the lower prices. New fixed income investments, whether of newly issued debt or marked down existing issues, provide greater income.
Focus on the total return – both price and income –as you evaluate bond performance. During the more volatile period of rising rates, you may consider investing in shorter-dated maturities, which should be less sensitive to interest rate swings. Of course, the shorter the maturity the lesser the income.
Will Inflation Return and What Does That Mean For My Portfolio? Talk of inflation is rampant given recent data and speculation about the new administration’s potential deficit producing policies. Inflation is generally bad for bonds because the securities pay set interest payments. These payments become less valuable when inflation is stoking prices.
You may consider Treasury Inflation Protected Securities (TIPS) to protect your portfolio. TIPS are structured to grow their principal value as inflation rises, which boosts both income and enhances returns. Inflation is why most portfolios include equities, as rising dividend yields can offset price increases.
Of course, inflation may not return or it may be less than forecast. The Fed’s interest rate hikes are designed to cool the economy.
Should I Expect Volatility to Increase? Possibly.
With a new president and a Federal Reserve that has signaled its willingness to move forward with rate increases, there is much uncertainty. However, we began 2016 similarly pessimistic and ended up with a generally positive year for bonds, demonstrating that no one has a crystal ball for predicting the bond or equity markets.
Investors should keep in mind that a bond bear market is not nearly as violent as an equity one. Despite 2013’s tantrum bonds delivered a total return of -2.04% for the entire year as measured by the Barclay’s Aggregate Index.
What are Some Strategies to Protect My Portfolio? In addition to buying shorter maturities as rates are rising, you may also focus on buying direct issues versus funds. Those investors know, absent a credit event, exactly how much and when they will receive their principal back, no matter what rates do.
Investors in individual bonds can also ladder their holdings to represent different maturities along the yield curve. This tempers volatility, and as one bond comes due, the proceeds from this lowest rung can be reinvested in a longer-maturity rung on the ladder, likely with a higher coupon and higher income stream.
Finally, diversify your bond holdings. Different types of securities react differently to rising rates. A mix of corporate, municipal and agency securities should perform better than one positioned exclusively in U.S. Treasuries.
Keep your eye on what bonds deliver: diversification, a steady income stream, and a potential haven from equity volatility. Although investors may be tempted to bail on the bond market given the post-election uncertainty and the Fed’s new rate signals, staying the course and selectively choosing fixed income investments is the better course of action.
Note: Elaine Phipps, MBA, CFA, is a Portfolio Manager at Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Ave., Summit.
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