Know What You Own
Are bonds still a solid play?
By Richard Kalfayan Jr.
Since the financial crisis began to unfold in 2007, the Federal Reserve Bank has kept short-term rates artificially low to stimulate the U.S. economy. Now that the economy appears to be on more solid footing, the Fed is expected to adjust interest rates. But that rise could cause volatility in bond prices—and interest rates are one of the biggest drivers of bond prices. Indeed, as interest rates rise, the value of a high-quality bond (or bond fund) falls, and vice versa.
If you own U.S. fixed-income securities, you need to think differently about how you invest in the rising interest rate environment that is approaching.
Diversifying allocations and staying informed is key. Whether you already own bonds—individually or through managed strategies—or are planning to purchase them, it is important to understand the principles that underlie fixed-income investing.
While the global banking system is more stable than it has been in the past, there is generally less liquidity in fixed-income markets today than before the credit crisis. Liquidity—the ability to quickly convert a bond into cash by selling (without dramatically affecting its price)—is a dynamic feature of bond investing that can change abruptly in response to supply, demand and other market forces. These factors can help determine whether a particular bond is an appropriate fit in your overall portfolio and suitable for your time horizon and risk tolerance.
In addition to a bond’s liquidity characteristics, other factors, such as interest-rate risk and credit risk, are important when evaluating a bond for purchase. As a general rule, if you are a “buy-and-hold” investor who expects to keep your bonds to maturity, you’re typically impacted less than a short-term or trading-oriented investor who wants to be able to sell bonds at any given time.
Core bond holdings remain an important component of diversified multi-asset portfolios. Core bonds—U.S. Investment grade Government, Corporate, Agency and Mortgage-related bonds—are often the anchor of a portfolio when equity markets are volatile. Buying these securities in a rising-rate environment can expose investors to capital losses as bond values fall, but if you intend to hold them until they mature, rising rates generally won’t have any effect on the income you receive.
If a temporary jump in longer-term interest rates occurs (as a result of speculation and fear, rather than market fundamentals such as demand or credit risk), investors may look to buy longer-dated bonds to lock in those higher market rates. This is particularly relevant if you are an income-focused, long-term investor.
Municipal bonds are also subject to interest-rate risk. However, their after-tax yields can look more attractive today compared to taxable bonds of similar quality, especially if you are subject to the highest marginal tax rate or the surtax on investment income. A “laddered” approach of blending bonds of various maturities to provide liquidity and flexibility for reinvestment, is worth considering.
High-yield bonds may offer a higher return than government bonds, but there is a greater risk of default. Still, given the historical performance of high-yield credit spreads (the yield advantage higher-risk bonds offer investors) in rising-rate environments—and the expectation of modestly rising longer-term U.S. interest rates and below-average defaults—you might be comfortable holding some high-yield fixed-income bonds this year as part of a diversified portfolio.
The emerging-market bond market has both matured and greatly expanded in the past decade thanks to higher yields and diversification benefits. But in addition to interest-rate risk, emerging-market bonds are often subject to country- and company-specific risk. Exposure to these bonds may be advantageous, but given the challenges in emerging markets, investors should focus on security selection and higher credit quality emerging-market sovereign and corporate bonds.
Know what you own. A rising-rate environment requires investors to stay informed. Have a conversation with your financial professional to better understand the changing climate and ensure that your investment portfolio is aligned with your long-term goals.