With the Federal Reserve resuming normal monetary policy, fixed-income analysts say investors should start reviewing their portfolio holdings now to see if their current allocations still make sense.
During the credit crisis, the Fed kept interest rates near zero and bought fixed-income securities to keep rates low and increase the money supply, a practice known as quantitative easing. With interest rates at rock-bottom, income-oriented investors looked outside of traditional fixed-income vehicles to generate cash flow, often buying riskier assets like high-yield bonds or dividend-paying stocks instead.
[See: 10 Dividend Stocks Boasting 100 Years of Payouts.]
As the economy grew, the Fed started raising rates slowly and at its last meeting said it would not reinvest the expiring bonds it bought during quantitative easing. The consensus view is that the central bank will raise interest rates again at its December meeting.
Although these moves are expected to lift interest rates across the yield curve, fixed-income market watchers don’t expect yields to spike any time soon. But that doesn’t mean income investors should be complacent, either.
Stocks and bonds revert to their traditional roles. After years of quantitative easing, markets are returning to their traditional roles, in which investors buy stocks for capital appreciation and bonds for income, says Matt Freund, co-chief investment officer and head of fixed-income strategies for Calamos Investments in Naperville, Illinois. “When 2008 hit, [tradition] was turned on its head,” he says. People were buying stocks for income because Treasuries didn’t really yield all that much. Now “we’re headed into a period of fixed income returning to its traditional role.”
Still, Freund doesn’t expect rates to go sharply higher over the next six to 12 months.
Katherine Schoen, manager of equity and fixed-income research for Baird’s private wealth management group in Milwaukee, says income investors should question the purpose of their holdings. Are these investments for income, diversification or part of an asset allocation strategy? “You really need to get that question answered,” she says. “You can’t have everything.”
That doesn’t mean jettisoning existing holdings, but you should re-evaluate your risk appetite and consider how much you will tolerate changes in equity prices, known as volatility, Schoen says. Investors who relied on bond proxies, such as dividend-paying stocks for income, may be taking on extra risk.
With the stock market at an all-time high, income investors may be overexposed to equity risk, she says. A pullback in stocks and bigger price swings could hurt investors, especially those who took on more equity risk to compensate for stagnating fixed income, she adds.
How should people invest for income now? So far, investors who hold riskier bond proxies have been OK because the Fed has been moving subtly, says Jim Barnes, senior vice president and director of fixed income at Bryn Mawr Trust in suburban Philadelphia. Although the central bank already has raised rates three times since December 2016, the 10-year U.S. Treasury note has only risen about 20 basis points.
[See: 9 Ways to Invest in America With Bond Funds.]
Domestic and global economic growth also have helped investors, he says. If growth continues, individuals with larger risk appetites could still hold those higher-yielding bonds and stocks without many issues.
“It’s OK to have a mix of fixed-income assets,” he says. “If you wanted to have sectors outside the U.S. for diversification purposes, I think there are some compelling reasons to do so. But do your research first. That has to be the ultimate driving factor.”
Noelle Corum, a portfolio manager at Invesco in Atlanta, says economic growth is likely to be a bigger driver of markets than central bank policy is now. Her team expects the Fed to raise rates in December and to do so again three more times in 2018. Nevertheless, she predicts the pace will be gradual enough that the markets can handle the rate hikes without slowing down growth.
Like Barnes, she believes the markets have absorbed previous Fed rate hikes and says continued low inflation will give the central bank the flexibility to revert to a normal monetary policy gradually. Based on this outlook, Corum favors asset classes, such as investment-grade bonds, high-yield bonds and emerging markets, that will benefit from stronger growth even as rates rise.
Given valuations are lofty everywhere, no sector of the market looks overly attractive for investors, but staying in cash isn’t an option either, says David Violette, senior fixed-income analyst at Baird. Instead, he recommends investors take advantage of the potential of rising rates with a classic bond ladder that has short-term, intermediate- and long-term fixed-income investments with maturity dates spread out evenly over time. When the instruments mature, the proceeds are reinvested. The benefit of this strategy is “you take what the market gives you without making any predictions of what’s going to take place,” he says.
[See: The 9 Best Municipal Bond Funds for Tax-Free Income.]
Ultra-low interest rates kept most investors in short-duration fixed income — that is, instruments that would mature in a short time. Even though rates may rise slightly, Barnes and Corum advocate remaining in products with shorter durations of one month to five or six years rather than longer-dated investments. Corum says shorter-duration trades will perform better if the economy continues growing, and Barnes still considers longer-duration maturities a risk as income returns are likely to stay low.
“Because we are in such a low interest rate environment, price volatility becomes hugely important to that return,” he says. “In that context, it doesn’t make sense to go too far out on the yield curve to pick up more yield given the amount of risk you’re taking on.”
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What Income Investors Can Expect From Rising Rates originally appeared on usnews.com
