As we slowly work our way out of this historic recession, it’s a good time to take a step back and think about where we might be headed and what it could mean for the fixed income holdings in your portfolio.
In December of 2008, the Federal Reserve dropped interest rates to record lows and began several programs intended to help the economy through the recession.1 Now that the economy seems to be stabilizing, the Fed is looking to unwind these activities over time by tightening the availability of credit and increasing the target interest rate.
The Fed’s implementation of these plans will likely correspond with an expanding economy, which I believe we will see over the next few years. Bonds will be directly impacted by an increase in interest rates, with the result of higher bond yields and lower prices. Of course, there are other factors that affect individual bond prices, including credit quality and maturity, but broad interest rate increases will tend to suppress prices across the market.
In an environment of falling prices, it is my opinion that individual bonds have important advantages over bond mutual funds. While both investments should experience falling prices, investors holding a portfolio of individual bonds can carefully analyze the credit quality of their holdings and hold them to maturity, while continuing to collect a stable return.
On the other hand, investors in bond mutual funds can be adversely affected by the actions of other investors in the fund. During challenging times, price volatility can make investors nervous, resulting in increased withdrawals from the mutual fund. In the face of such pressure, funds may be forced to sell their highest quality bonds at lower prices in order to meet redemption requests. The result is a further reduction in the share price and an unfavorably restructured portfolio.
Creating your own portfolio of individual bonds generally requires a greater capital investment and proper investment expertise. Investors interested in exploring this strategy should feel free to call me in order to gauge the suitability of maintaining a separate portfolio and to determine an appropriate risk profile. Make sure that you understand the strategy for your portfolio and feel comfortable with its risk level. Also, keep in mind that even the highest quality bonds are an investment, and thus carry a variety of risks, including illiquidity.
Mutual funds, despite their drawbacks, are still a good way to gain exposure to the fixed income market at a lower level of investment. However, I often recommend exchange traded funds, or ETFs, as an alternative. Index ETFs are available for a variety of fixed income categories and generally charge lower fees than their other mutual fund counterparts. Whatever your choice of fund, there are a few general points to keep in mind. Take note of the size and scope of the portfolio, as interest rate changes will have a different effect on bonds of different maturities and risk profiles. If you are uncertain about your appetite for risk, you may want to consider funds comprised of high quality, short term bonds, which generally fluctuate less in price and generate a correspondingly lower yield.
Bonds contain interest rate risk (as interest rates rise bond prices usually fall); the risk of issuer default; and inflation risk. The municipal market is volatile and can be significantly affected by adverse tax, legislative, or political changes and the financial condition of the issuers of municipal securities. Interest rate increases can cause the price of a debt security to decrease. A portion of the dividends you receive may be subject to federal, state, or local income tax or may be subject to the federal alternative minimum tax. A portion of the fund’s income may be subject to state taxes, local taxes and the federal alternative minimum tax.Please carefully consider the ETF’s investment objectives, risks, charges, and expenses before investing.
An investment in the Funds is subject to risk, including the possible loss of principal amount invested. The risks associated with each Fund include the risks associated with the underlying ETFs, which can result in higher volatility, and are detailed in each Fund’s prospectus and on each Fund’s webpage.
Exchange Traded Funds are subject to risks similar to those of stocks and will fluctuate in response to the activities of individual companies and general market and economic conditions domestically and abroad. When redeemed, you may gain or lose money.
Foreign investments involve greater risks than U.S. investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets.
If you are seeking detailed information about rolling over your 401(k) or about managing your IRA, I highly suggest downloading my free eBook, “10 Tips You Need to Know About Your IRA Rollover”. This short book is packed with critical information that will help you make the right decisions about your retirement savings.
Written by Bradford Pine
Bradford Pine Wealth Group – New York City Financial Advisors
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