Fixed-income investments are designed to give investors more predictable returns. According to the American Association of Individual Investors’ April 2017 survey, fixed-income investments account for the largest percentage of individual investors’ portfolios since July 2016.
[See: 7 Dividend ETFs for the Income-Minded Investor.]
A new BlackRock survey suggests that Americans still have a lot to learn about fixed income, however. One of the biggest misunderstandings concerns the relationship between interest rates and bond prices. Only 31 percent of investors knew that rising interest rates correlate with falling prices, the survey found.
“There’s an inverse relationship between interest rates and the price of a bond,” says Nahum Daniels, a certified financial planner with Nahum Daniels LLC in Stamford, Connecticut. “Many people find this hard to understand, but it’s really very simple.”
Daniels uses this example to illustrate interest rate risk: “Think of it this way, if you lent the government $1,000 at 2 percent interest, you would earn $20 per year. If the interest rate doubled to 4 percent, an investor would only need to buy a $500 bond to earn the same $20 in interest, meaning the value of the bond has been cut in half,” he says. “On the other hand, if you spend $1,000 to buy a bond that pays 4 percent and interest rates drop to 2 percent, your bond is now worth $2,000.”
Rising rates have a silver lining. The effect rising rates have on bonds depends on how they’re held. If you own individual notes, they will continue paying the same coupon rate until maturity, even if prices decline. The price only matters if you sell.
Bond funds, on the other hand, feel the market’s effects immediately. Because there’s no preset maturity date, the fund’s total return could decrease as interest rates rise.
But there’s also a silver lining when interest rates climb.
Although the market value of a portfolio of bonds will decline, “higher interest rates give bond investors the opportunity to invest new dollars and dollars from maturing bonds at higher returns,” says Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott in Philadelphia.
That scenario especially benefits long-term investors, LeBas says. He recommends that investors who hold government bonds directly ladder a portfolio with different maturity dates to capitalize on steadily increasing rates.
You need some foreign exposure. Insufficient diversification is another problem. Sixty-nine percent of investors in the BlackRock survey said they’d be more comfortable investing in domestic bonds versus those issued foreign countries. While that doesn’t necessarily mean your fixed-income portfolio needs overhauling, you should consider how diversified those investments are.
“The largest portion of the world’s bonds are issued in the U.S.,” and because U.S. bond investors are also consumers who use dollars, it makes sense for these investors to hold at least 75 percent U.S. bonds, LeBas says. “In the long run, diversification into foreign developed bonds may help tamp down the volatility of a bond portfolio, while emerging market bonds may help boost returns.”
Before investing in bonds issued by a foreign government, study those markets first. According to LeBas, currently low yields in non-U.S. developed markets and lofty valuations in emerging market bonds don’t justify high allocations to either one.
[See: The 9 Best Municipal Bond Funds for Tax-Free Income.]
The bond market carries risk. Fixed-income investments are not risk-free, but nearly one-third of investors in the BlackRock survey incorrectly believed they couldn’t lose money in bonds.
“Investors need to keep in mind that bonds and bond funds can lose value. Fixed-income risks are usually related to the term of the investment, the credit quality and the liquidity of the market,” says Tracie McMillion, head of global asset allocation for Wells Fargo Investment Institute in Winston-Salem, North Carolina.
Thomas Walsh, a certified financial planner and portfolio manager with Palisades Hudson Financial Group in Atlanta, cautions bondholders about boosting yield in a fixed-income portfolio.
“Some risks aren’t worth taking. Long-term rates are very low. If they rise significantly, you can lose a lot of money in a long-term bond fund,” Walsh says. “In the current environment, the higher yield is typically not worth the increase in risk.”
Investors should also consider the risk profile of other fixed-income investments, such as exchange-traded funds, mutual funds, money market funds and certificates of deposit, and how their risk corresponds to returns when rates rise.
“All fixed-income products are not equal and should be viewed differently,” says Jay Sommariva, vice president and senior portfolio manager at Fort Pitt Capital Group in Pittsburgh. “CDs offer FDIC insurance but don’t yield as much as a high-yield fund. Just like other investments, investors must weigh the risk with the return.”
With more rate hikes likely in 2017 and 2018, fixed-income investors should pay attention to rates and adjust their strategy accordingly.
John Donaldson, vice president and director of fixed income at Haverford Trust in Philadelphia, says bondholders should resist the temptation to take on more risk simply because rates have started rising.
“This cycle is likely to be long and gradual,” Donaldson says. After low rates for so long, it’s human nature to be impatient, but “those who exercise patience should be rewarded.”
Donaldson says investors should beware of the risk of extension, which occurs when a note’s maturity date is pushed back by the bond issuer.
“Whatever extra yield you get today doesn’t compensate you for that potential downside,” says Donaldson, who advocates that investors adopt a healthy skepticism and learn everything they can about their bond investments.
[See: 10 Skills the Best Investors Have.]
For Daniels, managing risk as rates rise is a matter of managing duration.
“If you’re really concerned about managing price risk, you have to go short term,” Daniels says. “That will lower the risk, but there’s a cost, which is abandoning returns. Low risk, low return. Those are some of the rules of the game.”
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What Investors Should Know About Bonds originally appeared on usnews.com
