These helpful hints offer ways to get a grip amid the threat of rising interest rates.
These helpful hints offer ways to get a grip amid the threat of rising interest rates.
Will investing in bonds be a sucker's bet in the months and years ahead? And if so, are there any ways you can protect yourself?
Investors--especially retirees and pre-retirees--have been pondering these questions lately, and for good reason. After all, the conventional wisdom on asset allocation is that folks getting closer to retirement should steer ever-larger shares of their portfolios into fixed-income securities, but the math for bond investors isn't particularly compelling right now. Current yields, historically a good predictor of bond returns, are ultralow. And the tailwind enjoyed by fixed-income investors in the past--namely, two decades' worth of declining interest rates that pushed up bond prices--is quickly receding into the rearview mirror. Rather than seeing their capital appreciate, bond-fund investors could actually see real declines in their principal values if rates head up.
Spread It AroundIn a rising-rate environment, so-called spread bonds, namely, anything other than government bonds, will generally hold up better than government bonds. The reason is straightforward. U.S. government bonds have the highest possible credit quality, so the government is able to get away with offering investors relatively skimpy yields because the risk of default is so low. That gives them less of a yield cushion to offset principal losses when rates tick up. Meanwhile, less creditworthy issuers, such as corporations, have to sweeten the pot for investors by offering richer yields, which in turn provide more of a buffer when interest rates go up. (Even if the bonds' prices decline, the higher yields help offset the drop.)
That argues for maintaining a well-diversified bond portfolio and steering a share of it into bank-loan investments, corporate bonds, and even high-yield corporate bonds, all of which typically protect against rate-related losses much better than government bonds. Because such investments are sensitive to the direction of the economy, and rates often head up when the economy is good, it also stands to reason that they would fare well during a period when rates are rising. At the same time, remember that in a true flight to quality, such as 2008's market panic, government bonds will generally perform better than all other types of credits.
Diversify Your Entry PointWhile you're thinking about diversification, it's also worth thinking about time diversification--staggering any future purchases of bonds that you have planned. For example, if you're rebalancing or you've crunched the numbers on your optimal asset allocation and found that your current bond stake is lacking, you can move your money into the market during a period of months rather than all at once. By spacing out your purchases, you'll avoid plowing a bunch of money into the fixed-income market just in time to see the asset class stumble. You'll also be able to take advantage of periodic hiccups in the bond market to buy in at more advantageous prices.
Consider Dividend-Paying Stocks but Don't Get Carried AwayMany Morningstar.com users have been enthusing about dividend-paying stocks as an alternative to bonds. Not only are yields on some dividend payers comparable or even higher than what you're getting to hold the same company's bonds, but stocks also offer appreciation potential that just isn't there for bonds.
But dividend payers shouldn't supplant their fixed-income stake entirely, as I discussed in this article. For one thing, the volatility profile of any stock, even the most reputable blue-chip dividend payer, is much higher than that of the typical bond. If you're holding bonds because you need stability of principal to fund goals within the next several years, dividend payers may exhibit bigger fluctuations than you bargained for. Also, it's a mistake to overestimate dividend payers' imperviousness to interest rates. After all, bonds slump when rates rise because there are new, higher-yielding alternatives on the market, and there's no reason to assume that dividend payers wouldn't be vulnerable to that same phenomenon. When interest rates jumped in 1994, for example, so-called equity-income funds landed in the red for the year, whereas the S&P 500 actually posted a gain.
DelegateIf you're nervous about your fixed-income investments and would like to take action, one sensible way to do so is to steer a portion of your fixed-income portfolio to a professional fund manager who has a full suite of tools at his or her disposal to steer clear of land mines and capitalize on short- and long-term opportunities. Although some investors might like the control associated with owning investments geared toward very specific slices of the bond market, an investor's best friend right now may be a truly active manager. (Bill Gross' recent foray into munis is a perfect illustration of what I'm talking about.)
Morningstar's Fund Analyst Picks in the intermediate-term bond category include a number of flexible funds, such as Harbor Bond , Metropolitan West Total Return Bond displayPTip('MWTRX', 'MWTRX','YTD', '', '', '', '', '', '','msg','P');, and Dodge & Cox Income displayPTip('DODIX', 'DODIX','YTD', '', '', '', '', '', '','msg','P');. Morningstar director of fixed-income research Eric Jacobson is also enthused about PIMCO Unconstrained Bond displayPTip('PUBAX', 'PUBAX','YTD', '', '', '', '', '', '','msg','P');, a true go-anywhere fund in the multisector category. (Harbor Unconstrained Bond displayPTip('HAUBX', 'HAUBX','YTD', '', '', '', '', '', '','msg','P'); is a no-load version.)
See More Articles by Christine Benz
New! 30-Minute Money Solutions Need help picking up the pieces in this turbulent market? 30-Minute Money Solutions by Morningstar director of personal finance Christine Benz simplifies the daunting task of getting your financial house in order. Written for novice and experienced investors alike, this book offers manageable, step-by-step solutions for tackling money challenges and building a comprehensive financial plan in simple 30-minute increments. Learn more. Order Your Copy Today--$16.95Fixed-income investors recently got a taste of what the future could hold, with bonds of all stripes, but especially rate-sensitive long-term Treasuries, slumping during the past month and a half. While it may provide near-term comfort to take action against the impending threat of further rate increases by, say, shifting your entire fixed-income position to cash, I think a more nuanced approach is in order.
Here are some of the key tips to consider as you navigate a worrisome fixed-income environment.
Let Your Time Horizon Be Your GuideIf you find yourself very concerned about the prospect of higher rates, that's an indication that your time horizon for your fixed-income assets is shorter than it should be. Although the low-yield environment of the past several decades has prompted many investors to steer assets they would have otherwise earmarked for cash into bonds instead, it's not a good time to be taking on extra interest-rate risk. Retired folks should have a minimum of two years' worth of assets in cash, true cash. Assets earmarked for needs in three to five years should be relatively safe in short-term bonds.
If your time horizon is five years or beyond, you can think about intermediate-term bonds. Because you expect to hold your investment for at least five years, you'd have a good shot at recouping your initial investment, even in a sustained period of rising interest rates. The yields on the bonds in the portfolio would go up, thereby offsetting any principal losses from selling bonds that had depreciated in price.
If your fund doesn't have a stated focus on short-, intermediate-, or long-term bonds, checking up on its duration can provide a sense of what's an appropriate holding period. If your time horizon for that bond fund is much shorter than a portfolio's average duration, that's a sign that you're in the wrong investment. In addition, you can stress test the interest-rate sensitivity of your bond funds, as I outlined in this article.
Acknowledge What You Don't KnowIt may look like a no-brainer that bonds will be in for tough sledding in the future. But sure things in investing have a way of not playing out like conventional wisdom suggests, or they unfold spanning a period of years and decades rather than days and months. The first step in navigating the current fixed-income environment ably, then, is to acknowledge that you don't truly know what will happen with rates and, in turn, bonds. Yes, the recent rate spike could be a harbinger of more bad news for bonds, and it's also hard to see if bonds can return as much during the next decade as they have during the past one. But rates could also tread water for another year or more, a view held by many professional fund managers; under such a scenario, prematurely shifting into cash carries an opportunity cost.
It also pays to recognize that the market for high-quality bonds is a pretty efficient, so if you're making a big bet that current bond prices aren't properly discounting the prospect of higher rates, you're essentially saying that you know more than other market participants, including professional money managers. For all of these reasons, it's rarely a good idea to position your portfolio to benefit under a single scenario.
Avoid the Obvious Trouble SpotsEvery bond bear market is different. But if rising rates are the catalyst for a sell-off in bonds, then long-term bonds, especially long-term government funds, usually get clocked the hardest. In the recent bond-market sell-off, for example, long-term government funds were the worst-performing category. True, long-term bond funds have sterling long-term returns, but because of their extra rate sensitivity, they've also been more than twice as volatile as intermediate-term bond funds. If you're concerned about rising rates, long-term bonds are an obvious area to avoid. (If you own an active fund, your manager might already be de-emphasizing them for you.)
Return to DiscussNext21PrevBe Seen. Be Heard. Become a Morningstar Contributor.Reach a readership of advisors, professionals, and active investors. Submit your commentaries for publication on Morningstar.com.
Securities mentioned in this article Ticker Price($) Change(%) Morningstar Rating Morningstar Analyst Report With Morningstar Analyst reports you can get our expert Buy/Sell opinions on over 3,900 Stock and Funds Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies. Video Reports Tax Bill a Stimulus in Disguise More Videos... Most Popular Related News Also in Investing Specialists Sponsored Links Buy a Link Now Sponsor Center Please Wait... BONDS USA_DODIX,USA_HABDX,USA_MWTRX,USA_HAUBX,USA_PUBAX FO_USA_DODIX FO_USA_HABDX FO_USA_MWTRX FO_USA_HAUBX FO_USA_PUBAX &primaryKeyword=BONDS 2 {CommentWebService} OAS_AD('Bottom'); Content Partners Site Directory Site Map Our Products Corrections Help Advertising Opportunities Licensing Opportunities Glossary RSS Mobile Portfolio Affiliate Careers Company News International Sites: Australia Canada China France Germany Hong Kong Italy The Netherlands Norway Spain U.K. Stocks by: Title Ticker Popularity Interest Funds by: Title Symbol Popularity Interest Articles by: Title Date Popularity Interest Stock Groups by: Popularity Interest Favorites Title Fund Groups by: Popularity Interest Favorites Title Article Groups by: Popularity Interest Favorites Title Premium Stocks by: Title Ticker Popularity Interest Premium Funds by: Title Symbol Popularity Interest Premium Articles by: Title Date Popularity Interest Independent. Insightful. Trusted. Morningstar provides stock market analysis; equity, mutual fund, and ETF research, ratings, and picks; portfolio tools; and option, hedge fund, IRA, 401k, and 529 plan research. Our reliable data and analysis can help both experienced enthusiasts and newcomers. © Copyright 2010 Morningstar, Inc. All rights reserved. Please read our Terms of Useand Privacy Policy.Dow Jones Industrial Average, S&P 500, Nasdaq, and Morningstar Index (Market Barometer) quotes are real-time. Russell 2000 quote is 10 minutes delayed. var HeaderBox = initBoxQuote("AutoCompleteBox","AutoCompleteDropDown"); HeaderBox.IdleDisplayMsg = ""; HeaderBox.LocalRegion="USA"; HeaderBox.SetPreference('USA','EN',32); var FooterBox = initBoxQuote("AutoCompleteBoxFooter","AutoCompleteDropDownFooter"); FooterBox.IdleDisplayMsg = ""; FooterBox.LocalRegion="USA"; FooterBox.SetPreference('USA','EN',32); //clears all content/image boxes-------------------------------------------------------------------------------------- var imageIDs=new Array('siteDirectoryContent', 'siteMapContent', 'productsContent'); //content boxes .mi_row3{display: none} var _gaq = _gaq || []; _gaq.push(['_setAccount', 'UA-16669347-1']); _gaq.push(['_setDomainName', '.morningstar.com']); _gaq.push(['_trackPageview']); (function() { var ga = document.createElement('script'); ga.type = 'text/javascript'; ga.async = true; ga.src = ('https:' == document.location.protocol ? 'https://ssl' : 'http://www') + '.google-analytics.com/ga.js'; var s = document.getElementsByTagName('script')[0]; s.parentNode.insertBefore(ga, s); })(); var Name = $('meta[name=DC.Creator]').attr("content").split(','); var Title = $('meta[name=DC.Title]').attr("content"); var URL = window.location.href; var Author = Name[1] + " " + Name[0]; var PubDate = $('meta[name=DC.Date]').attr("content"); _gaq.push(['_trackEvent', 'Article Title From Morningstar', Title, URL]); _gaq.push(['_trackEvent', 'Author Name From Morningstar', Author, URL]); _gaq.push(['_trackEvent', 'Article URL From Morningstar', URL, Title + "(by " + Author + " on " + PubDate + ")"]); _gaq.push(['_trackEvent', 'Publish Date From Morningstar', PubDate, URL]); _gaq.push(['_trackEvent', 'Article Title', Title, URL]); _gaq.push(['_trackEvent', 'Author Name', Author, URL]); _gaq.push(['_trackEvent', 'Article URL', URL, Title + "(by " + Author + " on " + PubDate + ")"]); _gaq.push(['_trackEvent', 'Publish Date', PubDate, URL]);See More Articles by Christine Benz
Fixed-income investors recently got a taste of what the future could hold, with bonds of all stripes, but especially rate-sensitive long-term Treasuries, slumping during the past month and a half. While it may provide near-term comfort to take action against the impending threat of further rate increases by, say, shifting your entire fixed-income position to cash, I think a more nuanced approach is in order.
Here are some of the key tips to consider as you navigate a worrisome fixed-income environment.
Let Your Time Horizon Be Your GuideIf you find yourself very concerned about the prospect of higher rates, that's an indication that your time horizon for your fixed-income assets is shorter than it should be. Although the low-yield environment of the past several decades has prompted many investors to steer assets they would have otherwise earmarked for cash into bonds instead, it's not a good time to be taking on extra interest-rate risk. Retired folks should have a minimum of two years' worth of assets in cash, true cash. Assets earmarked for needs in three to five years should be relatively safe in short-term bonds.
If your time horizon is five years or beyond, you can think about intermediate-term bonds. Because you expect to hold your investment for at least five years, you'd have a good shot at recouping your initial investment, even in a sustained period of rising interest rates. The yields on the bonds in the portfolio would go up, thereby offsetting any principal losses from selling bonds that had depreciated in price.
If your fund doesn't have a stated focus on short-, intermediate-, or long-term bonds, checking up on its duration can provide a sense of what's an appropriate holding period. If your time horizon for that bond fund is much shorter than a portfolio's average duration, that's a sign that you're in the wrong investment. In addition, you can stress test the interest-rate sensitivity of your bond funds, as I outlined in this article.
Acknowledge What You Don't KnowIt may look like a no-brainer that bonds will be in for tough sledding in the future. But sure things in investing have a way of not playing out like conventional wisdom suggests, or they unfold spanning a period of years and decades rather than days and months. The first step in navigating the current fixed-income environment ably, then, is to acknowledge that you don't truly know what will happen with rates and, in turn, bonds. Yes, the recent rate spike could be a harbinger of more bad news for bonds, and it's also hard to see if bonds can return as much during the next decade as they have during the past one. But rates could also tread water for another year or more, a view held by many professional fund managers; under such a scenario, prematurely shifting into cash carries an opportunity cost.
It also pays to recognize that the market for high-quality bonds is a pretty efficient, so if you're making a big bet that current bond prices aren't properly discounting the prospect of higher rates, you're essentially saying that you know more than other market participants, including professional money managers. For all of these reasons, it's rarely a good idea to position your portfolio to benefit under a single scenario.
Avoid the Obvious Trouble SpotsEvery bond bear market is different. But if rising rates are the catalyst for a sell-off in bonds, then long-term bonds, especially long-term government funds, usually get clocked the hardest. In the recent bond-market sell-off, for example, long-term government funds were the worst-performing category. True, long-term bond funds have sterling long-term returns, but because of their extra rate sensitivity, they've also been more than twice as volatile as intermediate-term bond funds. If you're concerned about rising rates, long-term bonds are an obvious area to avoid. (If you own an active fund, your manager might already be de-emphasizing them for you.)
Be Seen. Be Heard. Become a Morningstar Contributor.Reach a readership of advisors, professionals, and active investors. Submit your commentaries for publication on Morningstar.com.
Read Full Article »