Good question. But I’ve got a better one: What’s your investment time horizon? That’s how to start the bond conversation.
Investors are concerned about how the prospect of a continued rise in interest rates could impact portfolio valuations. For bond investors, rising rates— which move opposite to prices—can take a pretty good bite out of monthly statements.
Over the last year, we’ve watched rates on the 10-year U.S. Treasury increase by over 1% (100 basis points), which equates to a decline in price of approximately 4% on a bond or portfolio of bonds with an intermediate duration in the four-year range (a range often included in leading indexes). Unfortunately, there is no escaping that reality or relationship; as interest rates rise/fall, bond prices fall/rise.
The recent spike in rates has not been the result of Federal Reserve action. Rather, the rise has been the result of market reaction: that is, investors selling bonds (presumably at lower prices) out of fear that the Fed may taper or suspend bond purchases in the future as economic conditions continue to improve. In the meantime, the economic picture, albeit a bit rosier than in previous months, remains muted. The Fed has said they’ll maintain bond buying, or quantitative easing (QE), until annual inflation rises or the unemployment rate drops (the Fed has targeted a 6.5% rate, give or take; unemployment stood at 6.7% in December). We are not there yet, and it remains uncertain what the Fed will do in the near term.
Although increasing rates have hurt bond prices in the short run, some experts on Wall Street suggest that the market has already priced in the possibility that the Fed will reduce or discontinue the QE program that has helped to keep interest rates at historically low levels.
CONFUSED ABOUT FIXED INCOME?
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Don’t Bail On Bonds
The big question facing many investors is whether they should stick with fixed income or sell out now before the going gets worse. We believe that fixed income is an important part of an investor’s asset allocation. Fixed income continues to be a good portfolio diversifier, but expected returns for the asset class could be negative in the near term as the Fed and the market reach a normalized longer-term interest rate level.
Investors need to maintain a longer-term perspective when investing in fixed-income securities so that they can smooth out the price volatility associated with short-term fluctuations in interest rates and prices. Although bond prices may move negatively when interest rates rise, this price volatility will likely be offset over time as the interest income and maturing bond principal gets reinvested into higher-yielding securities. Those higher yields, given an appropriate time horizon, should help to mitigate price declines so that investors do not experience permanent loss of capital.
What is the appropriate time horizon for an investor who is faced with the rising rate conundrum? Fixed-income fund manager PIMCO conducted a study on the benefits of taking a long-term view when investing in fixed income. The study suggests that investors with an appropriate time horizon of at least one to three years generally achieved positive absolute performance when rates increased 1–2%. PIMCO cited that the benefit of higher reinvestment rates over a longer time horizon helped to offset much or all of the negative impact associated with climbing interest rates in the short run
HYPOTHETICAL BOND RETURNS IN DIFFERENT INTEREST RATE SCENARIOS
|1 YEAR||2 YEARS||3 YEARS||4 YEARS||5 YEARS||7 YEARS||10 YEARS|
WHAT REALLY MATTERS
Here’s what you should consider when contemplating rising rates and bond investments:
- Rising rates may indicate an improving economy.
- Higher rates mean better yields.
- With higher rates, coupon payments and maturing bonds can be rolled over into higher-yielding securities, potentially increasing the average return on a portfolio of fixed-income securities.
- Price declines associated with rising interest rates might be partially or completely offset by the higher-income return.
- Having high quality, actively managed fixed income mutual funds in your portfolio might help you better manage risk and may help you avoid large losses.
Despite extremely volatile conditions for interest rates in 2013, the total return of the Citigroup U.S. BIG Bond Index depicted in figure 1 is only down 1.1% as of mid-November 2013. What’s important to note here is that assuming interest rates rose by 1%, the study suggests that the portfolio may be “back in the black,” generating positive returns, by the next year. Using a more dramatic example, if rates spiked up by 2% in a given year, the investor would see negative total returns in years one and two but return to positive returns after year three. Further, in another study, TD Ameritrade generated a series of rolling three-year returns for the Citi U.S. BIG Index that goes back 20 years from October 2013 to January 1993. During those 20 years, the index did not register a single negative return over what turned out to be 205 examples. Although there is no guarantee that there will never be a negative return during any future three-year period, sticking with a longer time horizon should help investors experience positive bond returns as higher re-investment rates work to mitigate the negative price impacts associated with rising interest rates.
- Fund managers have the knowledge and professional judgment to effectively manage fixed-income mutual funds in a variety of market conditions. In fact, many of these managers have positioned their portfolios to try to mitigate the adverse effects associated with rising interest rate risk.
- Many fund managers seek to add value by investing in a wide variety of bond sectors (government agency, corporate, high-yield, mortgage-backed securities, international fixed income, etc.) that might offer more favorable yields with reasonable levels of risk.
Carefully consider the investment objectives, risks, charges, and expenses before investing.
Source: TD Ameritrade[/vc_column_text][/vc_column][/vc_row]