At the end of May the record flow of money into bonds that began years ago but significantly accelerated in 2008 made an abrupt u-turn based on concerns the Federal Reserve may begin to “taper” its huge asset purchase program called quantitative easing. The Federal Reserve Bank is in the 3rd round of quantitative easing (QE3) which they began in an attempt to stimulate economic growth after lowering short term interest rates to near zero didn’t have the desired affect. The volatility seen in the bond markets the last several weeks is being driven in large part by the fear that when the Federal Reserve stops buying bonds, interest rates will rise.
Bond prices and interest rates move inversely to each other. Think of a teeter totter in a playground. On one side are interest rates and on the other side is price. When interest rates push off and go up in the air, it drives the other side (price) down. In June, bond investors made like bananas and split. Does this mean you should sell your bonds if you already own them? Should you add bonds to your portfolio on the recent sell off?
As is always the case with investing, before determining what you should or shouldn’t do, you need to determine what you are trying to accomplish. Are you looking for a steady stream of income, price appreciation or principal protection and stability? What is your investment time horizon? When you start to answer these questions then you can begin to act or react to the recent rise in interest rates and bond market volatility.
Not all bonds are created equal. Most of the time when people in the media, investment analysts or economists talk about “bonds”, they are talking about US Treasury Bonds. But, there are many types of bonds, and other fixed income securities. Some of the more common sub-types are; municipal bonds, corporate bonds, convertible bonds, preferred stocks, floating rate bank loans, and international corporate bonds and government debt, US Government Treasury bonds and agency bonds issued by entities like Tennessee Valley Authority, and Federal National Mortgage Association (FNMA), Treasury Inflation Protected Bonds (TIPS). Often time’s bonds are mistakenly thought of as always being a safe investment, but investing in fixed income securities involves certain risks such as market risk if sold prior to maturity and credit risk especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than original cost upon redemption or maturity. All investments carry some sort of risk. That is why it is so important to take the time to understand what you are investing in and why.
If you’ve read some of my past columns you know I am a big fan of asset allocation. Although asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns, determining a mix of assets (stock, bonds, cash, real estate, commodities, etc) may help you meet a particular long term investment objective while attempting to match the risk and volatility of your portfolio to your level of tolerance. Once that mix is determined, you can periodically rebalance the portfolio to the original asset mix assuming your goals haven’t changed. As a simplified example, if you and your financial advisor have determined a good asset mix for your particular situation should consist of 60 percent stocks, 30 percent bonds, 5 percent cash, 5 percent commodities, as long as your goals don’t change, you can use this mix as your North Star, when it becomes significantly out of balance, reallocate. I like to do this annually and when there is a big move (5 percent or more) in any asset class.
In addition to rebalancing, there are things you can do within an asset class to adjust to new conditions like a rising interest rate environment. If you are worried about price volatility, you may want to shorten the maturities of the bonds in your portfolio. Go back for a minute to the teeter totter in the playground. Picture three bonds sitting on the “price side” of the teeter totter. A bond with a maturity of thirty years is sitting on the seat furthest out from the center, a ten year bond is in the middle and a bond with a maturity of one year is closest to the center. The interest rate on the other side pushes off from the ground and its side goes up in the air. On the price side, all the bonds go down but the thirty year moves a lot more than the one year bond.
If you need cash flow, you may want to consider moving a portion of your bond portfolio into investments that pay income but their price may not move in lock step with bonds. A couple examples are, real estate investment trusts (REITS) and high dividend paying common stocks. Convertible bonds, floating rate bonds and bonds with step up coupons may be something to consider in rising interest rate environments. Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations. There are special risks associated with an investment in real estate, including credit risk, interest rate fluctuations and the impact of varied economic conditions. Dividends are not guaranteed and are subject to change or elimination. So, although it is no guarantee of future results, it’s important to review a companies dividend track record including how stable it is, have they ever missed a payment, do they routinely increase the dividend, etc.
The only thing that is constant is change and without a plan, change can be scary. The funny thing is that the rising interest rates that are scaring everyone right now will eventually some time in the future be falling interest rates which I’m sure will cause a scare of their own. Let your plan be your refuge in stormy weather and don’t let rising interest rates get you down.
The investment(s) discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial circumstances. Additional information is available upon request