If the current interest environment has you concerned about your bond portfolio, remember why you are investing in bonds. The role bonds, or fixed income, play in a portfolio is not solely based on performance. Bonds are used to offer stability, particularly when stock market volatility is rising. Rate hikes can dampen bond performance, but keep perspective on how rising rates impact your investments over the long haul.
Generally speaking higher rates are better for long term bond investors. Higher rates equal higher income opportunities, allowing investors to offset price declines with the income paid by a portfolio’s fixed income investments. Another point to consider is if the Fed is gradually raising rates, and inflation is only modestly increasing, this is a signal that the economic outlook is strong and healthy. Fed rate increases go along with a robust job market.
Portfolio investment is not only about the return. Return is important, but for many investors capital preservation is equally important. Investors fear losses more than they enjoy gains. The goal is to achieve a portfolio balance so that the downside is not too excessive. Although your bond portfolio may not be making you much money, it is an important component in protecting principal and limiting sharp declines. Further, if you hold bonds to maturity, the yield at which you purchased the bond will hold true regardless of the direction market yields are moving. Absent a default by the bond issuer, the yield to maturity will remain constant and your principal is protected.
Bonds offer three types of benefits to an investment portfolio: diversification, stability and income.
Diversification. Fixed income investments are an important component of any diversification strategy. A portfolio owning different types of stocks and bonds is more likely to perform better over time with less volatility. Based on risk appetite and long term goals, maintain a balance between stocks, bonds and cash. Select bond holdings across different sectors and maturities. Reduce exposure to those bonds maturing beyond ten years. Diversify your stock positions across sectors and add international exposure. International stocks typically outperform during a U.S. Fed tightening cycle.
Stability. Bonds provide stability by helping to offset potential downturns in stocks, in part because their prices tend to rise when equity prices fall. Even if this does not hold in all market scenarios, they still provide a steady stream of income that will help to stabilize a portfolio's performance when other assets are declining. Returns can move in the opposite direction from stocks where the bond increases help to offset equity market losses. However, bonds don’t always show that kind of performance, especially during a period of rising rates. That doesn’t mean they are not doing their job. Even if bond returns are down, the magnitude of losses in bonds versus stocks is historically much less.
Income. No matter which direction bond prices are moving, the income you receive continues. A quarter point rate increase by the Federal Reserve won’t substantially impact investment returns. However, after a series of rate hikes and a trend of rates moving higher, it can be a drag on near term performance. As rates rise, bond prices decline, and investors may see losses on their bond positions. While seeing unrealized losses in the bond portfolio is never pleasant there are a few points to keep in mind.
It is important to look at the total return of the bond. The unrealized gain shown on a statement does not reflect the income paid semiannually on a bond or dividends paid monthly by a bond fund. This steady stream of income is adding to the bottom line and enhances performance.
Furthermore, because this income stream continues until maturity, the bond holder is locking in the yield at which the bond was purchased. The downside is that as interest rates continue to move higher, there will be missed opportunity to buy bonds at the new higher rates. For that reason, it makes sense to ladder a bond portfolio by owning bonds with different maturity dates so that bonds mature over consecutive intervals, providing the investor liquid funds to invest as rates move higher.
Don’t fear the rate hikes. It shows that the economy is healthy and it allows fixed income investors to lock in higher rates for long term investing.
Note: Donna St.Amant, MBA, is a Portfolio Manager at Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Ave., Summit.
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