After holding at very low levels for several years, interest rates are expected to climb this year, and that’s leaving many holders of U.S. Treasury notes feeling some pain.
As yields rise, prices for bonds fall, meaning holders of Treasury notes saw losses as the year wound down. The yield on the 10-year Treasury note rose as high as 2.6 percent in late December, its highest level since September 2014. Current yields are close to that level, holding around 2.5 percent.
The losses in Treasury notes are coupled with record-high gains for equities, with the Dow Jones industrial average crossing 20,000 points in January.
Investors followed the market action, spurred by optimism about the U.S. economy and expectations both interest rates and inflation will rise.
Morningstar says December’s overall inflows tally for U.S. stock funds hit its highest monthly total since April 2000 at $27.8 billion.
Income investors are justifiable nervous, especially since the Federal Open Market Committee raised rates in December and with the median estimate from FOMC members suggesting there will be more rate increases this year. Although actual rate hikes may not materialize, income investors are in a bit of a quandary now, especially if they’re smarting from losses in their high-grade debt asset allocations.
[See: 9 Psychological Biases That Hurt Investors.]
Still, market watchers say don’t abandon fixed-income investments. Rather, people need to review their holdings and consider why they have these investments.
Construct an all-weather portfolio. Mary Ellen Stanek, managing director and chief investment officer for Baird Funds in Milwaukee, says don’t try to time short-term direction of interest rates.
“Our advice to investors is to stick to the risk tolerance where you’re comfortable. Trying to move your portfolio and anticipate short-term direction of interest rates is a fool’s game,” she says.
“Instead try to figure out an all-weather position and stay there,” she says. ‘Step back and say to yourself, ‘Why do you own bonds in the first place?’ You try to own them to lower volatility and for cash flow properties.”
Peter Andersen, chief investment officer of Fiduciary Trust Co. in Boston, says people’s view of investing in fixed income right now is akin to “asking them to hold their hand in an open fire.”
However, like Stanek, Andersen says fixed income acts like an insurance policy in portfolios. While the current market sentiment favors a pro-growth, rising inflationary environment based on comments by President Donald Trump for more capital spending that may not materialize.
“If these things don’t turn out and Trump can’t get three-quarters or half of his plans approved, there is a chance the equity markets will sell off,” Andersen says. “If the markets sell off there will be classic flight-to-quality which means going back to fixed income.”
Warren D. Pierson, managing director and senior portfolio manager at Baird Funds, says while there might be some upward pressure on interest rates if there is economic growth, he notes a lot of the structural headwinds that have capped growth in the past several years are still around. Those include forces like aging populations and continued development of technology to replace jobs, which may stymie forecasts for strong growth.
Market of bonds. Matt Freund, co-chief investment officer and head of fixed income strategies at Calamos Investments in suburban Chicago, says there are many aspects to fixed-income investing, making it possible for investors to find something suitable, even in a rising-rate environment.
“People talk about the bond market like it’s monolithic, the bond market. It’s a market of bonds, not a solitary bond market,” he says. “Those bonds have different characteristics. Some we like, some we don’t.”
Freund says despite current fears about weakness in the bond market, the rise in interest rates from near zero is creating opportunities for investors who want longer duration. Until now, most investors have stayed in shorter duration notes, meaning those that will mature in a few years, versus longer-duration bonds, which may mature 10 years from now or later.
[See: 7 Stocks That Could Save Your Portfolio.]
As for where to look for income this year, Stanek and Pierson say they still like investment-grade corporate credit markets and their higher yields versus Treasury markets.
One way to invest in corporate credit is to have a financial advisor build a bond ladder where the bonds expire on a one- to 10-year time frame, and each year the bonds mature, a new 10-year bond is added to the mix, Andersen says. This concept is similar to the way income investors would build certificate of deposit ladders, he says.
Andersen says for income investors who want to stay in fixed income but think the economy will continue to improve might consider adding a little bit of high-yield debt, depending on their risk tolerance. He says manufacturers that issue high-yield bonds will likely see their outlooks improve if the economy picks up, and even if inflation rises, it’s likely they can pass on those costs.
The easiest way to do that is to buy an exchange-traded fund, such as the iShares iBoxx $ High Yield Corporate Bond ETF (ticker: HYG), he says.
A stock option. Damon Southward, chief market strategist at Briefing.com in Chicago, says some income investors may want to look to the preferred stock market as he expects greater issuance this year.
Preferred stock is a hybrid between common equity shares and a bond, he says, where they trade like a stock but have the features of a bond. They usually have higher interest rates and payments than a company’s common stock dividends, and there is some security that preferred stock holders have priority over common shareholders, too.
He says many companies have waited to issue preferred-stock shares, hoping interest rates would fall back, but they haven’t.
“The case I’m making in 2017 is that it’s going to be a really big year for the preferred market. In the next month or so, companies will realize rates not coming back in,” he says, adding that some preferred stocks have yields of 8 or 9 percent.
While he’s not advocating any companies at the present, for people who want to research preferred stocks, Southward recommends reviewing a company’s prospectus to understand their fixed cost and coverage ratio. That explains how much extra in earnings a company has over the preferred payment.
He says he looks for companies with a coverage ratio of at least two and one-half times and he also looks for companies whose common shares are above $20.
[Read: How to Invest in Bonds as Interest Rates Rise.]
“When stocks are trading at $20 to $30 companies can always raise capital with the stock to meet their needs,” he says. “That way I don’t necessarily have to stay on top of the company every quarter.”
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How to Play Income Investments When Rates are Rising originally appeared on usnews.com
