As published in
MD News June 2016
Country singer and actor Jimmy Dean once said, “I can’t change the direction of the wind, but I can adjust my sails to always reach my destination.” There is no better scenario in which to recall this sage advice than in the always-changing world of financial markets.
When the Federal Reserve Bank raised interest rates last December after nearly three decades of steady declines, the scenario for bond investing changed rapidly.
When interest rates go down, bond values tend to rise. For the past 34 years, a portfolio’s bond component has generally been predictable and profitable. The fixed income component of a portfolio typically offsets much of the overall volatility experienced by equities and also provides income.
Even 10 years ago, constructing a fairly stable bond ladder — a portfolio of bonds with significantly different maturities — that would generate decent yield and, in many years, produce solid total return over and above stated yields was relatively easy. We use the technique to reduce risks associated with bonds while simultaneously managing cash flows. For example, according to 2006 United States Treasury data, two-year corporate bonds yielded 4.9 percent, five-year corporate bonds yielded 5.06 percent and 10-year corporate bonds yielded 5.31 percent. By owning bonds of staggered maturities and holding them until maturity, investors would have received decent interest payments and had their principal returned at maturity even if interest rates had risen significantly. As it turned out, interest rates in general significantly decreased during the next decade, meaning the value of the underlying bonds increased significantly until the bonds matured or were sold. It was a wonderful time to be a bond investor. Cash flows were strong, total return was an added bonus and there was little risk.
Today, things are much different. Now, we’re living in an economic environment where “safe” means a return very close to zero. Corporate bonds with two-year maturities yield 1.67 percent, five-year corporate bonds yield 2.39 percent and 10-year corporate bonds yield 3.67 percent. As such, constructing a bond ladder resulting in similar results as it did in 2006 is challenging. Yields are too low, and we are likely entering a rising interest rate environment. As bond yields have dropped, bond values have risen, which means bonds are vulnerable to rising interest rates, especially if rates increase quickly.
While it is possible that rates may still decrease further (see the article on negative yields in the April issue of MD News), it is more likely that we are in the nascent phases of a rising interest rate environment. It appears that the Fed’s December decision to raise rates was an inflection point that has changed the 34-year trajectory of interest rates from down to up. The decision is likely an inflection point for bond values as well. The Fed has indicated that they would like to see rates increase further during 2016.
Normally, when interest rates have an upward trajectory, the Fed is responding to better economic conditions. By raising rates, the Fed can help keep the economy from overheating. While it doesn’t look like we’re in eminent danger of overheating, moving rates from their historically low level seems to be a sign of stabilization.
Bond ladders still work in a rising rate environment. As one bond matures, another should be purchased at the opposite end of the ladder, thus buying into a rising rate environment. As rates increase over time, the aggregate yield of the bond ladder will increase as well. The difference is that investors no longer receive the added benefit of bond value increases as a result of declining interest rates. In a rising rate environment, bond values could experience periods of decline. But if bonds are held to maturity, an investor will receive the par value at maturity. Income generated by the bond portfolio will not nearly be as great as it was during the past 24 years, so other strategies should be utilized if income generation is a high priority.
Including bonds in a portfolio, even when rates are rising, provides diversification. Bonds tend to even out some of the volatility of the equity portion of your portfolio. Bonds were never intended to provide inflation protection. Over time, equities have been a fairly stable inflation hedge, which is a main reason for holding equities in a portfolio.
We are likely entering a challenging period of time for investors. I suggest meeting frequently with your advisor to discuss how rising interest rates will impact your portfolio. If you’d like a second opinion on how your portfolio may respond to a shifting rate environment and how together we might adjust your portfolio’s sails, please feel free to contact me.