The bond market is in a good news, bad news situation. The bad news is that bond prices are down. That’s also the good news.
Here’s what long-term investors need to know: stay calm.
Here’s what happened in the fixed-income market: it sank. For instance, the iShares iBoxx Investment Grade Corporate Bond exchange-traded fund (ticker: LQD), which holds a basket of high-quality fixed-income securities, retreated 4.7 percent in the six months through Jan. 18, while the Standard & Poor’s 500 index gained 5 percent.
“Expectations of higher U.S. economic growth drove expectations of higher inflation, sending interest rates higher,” says Vinny Catalano, global macro strategist at Blue Marble Research in New York. Interest rates and bond prices move inversely, so higher interest rates mean lower bond prices.
[See: 20 Awesome Dividend Stocks for Guaranteed Income.]
The yield differences that sent the market down weren’t huge. Average high quality corporate bonds recently yielded 3.68 percent, versus 3.33 percent July 19, according to data from the Federal Reserve Bank of St. Louis. In total it’s less than 1 percentage point, but it was enough to sink the market.
But the decline in bond prices isn’t necessarily financially bad for investors who are looking for long-term gains.
“A rising-rate environment is a mixed bag for fixed-income investors,” says Stephen Wood, chief market strategist at Russell Investments in New York. “They take a price hit in the near term but that is counterbalanced with a higher yield going forward.”
Yes, you see some losses on your fixed-income investments initially, like the 4.7 percent mentioned above. But because yields are now higher, the income that the investment generates will be higher. And the higher income adds up quickly and compounds as the interest payments are reinvested.
There is another factor to consider. “Investors need to understand that the bond market has been in a 30-plus year bull market,” says Art Hogan, director of research and chief market strategist at Wunderlich Securities in New York.
In September 1981, the benchmark 10-year U.S. Treasury yielded 15.84 percent, versus 2.33 percent recently, according to data from the St. Louis Fed.
These securities are important because other borrowers all pay more than the U.S., which is considered a risk-free borrower.
Still, the big point is that investors should expect some increases in interest rates, hence some more pullback in bond prices. Expect higher income to compensate for the losses over time. In short, the higher rates will not necessarily be bad for long-term investors.
There are reasons bonds will be in demand going forward. First, the population is aging and retiring. Many individual investors should be in less risky assets than they currently hold, Hogan says.
[See: 10 ETFs That Pay Sky-High Dividends.]
Individual investors approaching retirement should probably hold more high-quality bonds, which will provide steady income. Such securities have low risk of default and they also do not usually have the periodic wild moves in price that stocks see.
In addition, bonds provide a useful diversification when held as part of a larger portfolio. “To the extent that growth disappoints expectations then bonds will outperform stocks,” says Jack Ablin, chief investment officer at BMO Private Bank.
If investors find their forecasts were too optimistic about the economy, then stocks will tend to fall and bonds will either fall less, or perhaps even rally. Either way, some investment allocation to bonds tends to make a portfolio less volatile than it would without them.
What’s the right allocation to bonds? This is a perennial question that market experts hate answering because investors all have different needs. Still, the base case for most people should be around 30 percent of a portfolio to fixed-income securities, with the majority of the allocation in high-quality bonds. As people get older they should consider increasing the portion. Likewise, anyone relying on income from investments should have a higher portion of bonds.
If you don’t have any bonds, now would be a good time to consider adding an allocation. For most individual investors, buying individual bonds doesn’t make sense. For those with substantial capital, Catalano recommends buying high-quality securities with a rating of BBB or better with maturities in the three- to seven-year range.
For the rest of us, try buying funds. In addition to the iShares ETF mentioned above, other suitable funds include PIMCO Investment Grade Corporate Bond ETF ( CORP) and the Vanguard Intermediate-Term Investment-Grade Fund Investor Shares ( VFICX). The latter two both have annual expenses 0.2 percent respectively. That is equivalent to $20 per $10,000 invested.
[See: 10 Long-Term Investing Strategies That Work.]
Some people may find that the alternatives in their company provided retirement plans don’t include those listed. That shouldn’t be too much of a problem as there are many other bond funds.
More from U.S. News
The 7 Best Bank Stocks to Buy for 2017
7 of the Worst Stocks to Buy for 2017
6 Famous Flameouts of Famed Investors
Why the Bond Market Pullback Shouldn’t Worry Investors originally appeared on usnews.com
