Additional interest rate hikes are a virtual certainty this year, following last year’s three increases. What’s less certain is how frequently the Federal Reserve will raise rates.
Rising rates, an indication of positive economic health, typically meet with less enthusiasm from fixed-income investors. As rates rise, bond prices fall, dealing a devastating blow to a fixed-income portfolio. “Things have been challenging for the short-term bond market for several years,” says Jeff Powell, managing partner at Polaris Greystone Financial Group in San Rafael, California.
Yields for short-term bonds have risen as a direct result of the Fed’s actions, prompting short-term bond prices to fall. Intermediate and long-term bonds have experienced the opposite effect — rising prices and falling yields — as foreign investors turned to short-term U.S. Treasury notes instead. “The 2018 outlook appears to be a repeat of what occurred in 2017, with the Fed expected to raise rates 50 to 75 basis points by year’s end,” Powell says.
[See: 7 Under-the-Radar Financials to Buy for Income.]
That’s probably not what you want to hear if your fixed-income investment returns faltered in 2017. “The Fed is tightening monetary policy, the yield curve is flattening, and credit spreads are near historically high levels,” says Brian Rehling, co-head of global fixed-income strategy at Wells Fargo Investment Institute in St. Louis.
But investors shouldn’t bail on bonds and fixed income altogether. Instead, this is the time to review fixed-income assets and adjust them to account for potential late-cycle risks. “Be thoughtful regarding fixed-income portfolio positioning,” Rehling says.
Investors need to rethink their definition of risk. Rising rates have a way of turning bond holdings upside down. “Typically, the bond portion of your portfolio is supposed to be the ballast, providing stability and income,” Powell says. The potential for bond losses from rising rates, however, can threaten that strategy.
Reallocating the fixed-income portion of your portfolio to include investments in foreign fixed income, inflation-protected products, such as floating-rate bonds, or convertible bonds, which don’t exhibit typical bond behavior, can help lessen the risk from rising rates. Shifting into bonds with shorter maturities — or a fund that invests in them — is another way to minimize flat fixed-income returns from longer-term bonds — or losses if you sell the bonds before they mature.
Investors may also want to steer clear of the fixed-income investments that are most at risk when rates rise. Longer-term bonds, for example, are the obvious casualties, says Jonathan Swaney, a portfolio manager at New York-based MainStay Asset Allocation Funds. “Bonds issued by heavily indebted companies are also at risk, as higher yields can impair their ability to service debt.” With stocks, “companies that offer a high dividend yield, especially those that tend to use significant leverage, like utility and telecommunication companies, may generate lower total returns than the broader market.”
Fixed-income investors with long-term bonds can easily be caught off guard by losses. “Shortening the duration of their bond portfolio while increasing cash holdings go a long way in taking the bite out of interest rate risk,” says Thomas Hudson, director of investment research at TFC Financial Management in Boston.
Lagging returns should be kept in perspective. Every portfolio needs different components to balance each other. For example, “bonds are key to providing capital preservation, steady income and a counterbalance to a falling stock market,” says Kevin Adkins, chief investment officer for Family Wealth Group in Lexington, Kentucky.
[See: 11 of the Best Fixed-Income Funds to Buy.]
That last bit is especially important if there’s a market correction. Stocks are riding an epic wave, but questions about this bull market’s longevity abound. Although they have low yields, bonds and other fixed-income assets also offer lower volatility, an attractive feature if stocks begin losing steam.
What matters most is the total return for the entire portfolio, says Philip R. McDonald, director of investments at Symmetry Partners in Glastonbury, Connecticut. “It’s not in an investor’s best interest to scrutinize the individual line items of their portfolio based on asset classes, funds or securities,” he says.
A broadly diversified portfolio will always have winners and losers, so your ideal asset allocation should reflect your long-term expectations and priorities, “not short-term predictions,” McDonald says.
This is no time to chase yields. For the past several years, investors have loaded up on credit risk in exchange for higher yield, often because of some misguided notion of what that yield should be, McDonald says. “A common behavioral bias is the expectation that income from a portfolio should be a specific percent because diversified bond portfolios may have achieved that in the past.”
There’s a problem with that strategy. “High yield as an asset class doesn’t behave like investment-graded fixed income through economic and credit cycles; it tends to be more equity-like,” McDonald says. When Treasury yields are rising and credit spreads increasing, investors with concentrated credit exposure may be less diversified and, as a result, suffer higher losses than they expect.
Trying to time the bond market is also a losing proposition. “Rarely, if ever, will you be able to purchase a security at exactly the right time to eliminate any negative return,” says Jay Sommariva, vice president and senior portfolio manager at Fort Pitt Capital Group in Pittsburgh. Just buy high-quality investments instead.
Before making a dramatic move in or out of bonds, Rehling advises investors to consider the asset’s total return, which includes interest income in addition to price returns, as that is the most accurate measure of fixed-income performance. “Investors who neglect interest income and consider only price movement are missing half the picture,” he says.
[See: 9 Ways to Invest in America With Bond Funds.]
Selling all your bonds to eliminate exposure to interest rate risk only creates a new risk — that of not meeting your investment goals. Moving into interest rate-hedged exchange-traded funds or Treasury inflation-protected securities for example, could make you feel more secure in the short term but cost you higher returns in the long run. “Sometimes, staying the course in the portfolio appropriate for your objectives and constraints is the best decision,” McDonald says.
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Get Your Fixed-Income Portfolio Ready for Rate Hikes originally appeared on usnews.com
