Are bonds still a conservative investment? With yields jumping dramatically this summer (and prices dropping), it’s hard not to notice the turmoil in the bond market. I’ve been stopped by many people with concerned questions about what to do, and this article was born out of those conversations.
The bond market almost certainly touches your portfolio, as most investors are exposed to bonds either through individual bonds or mutual funds within your 401(k), 403(b), IRA, and 529 plans, including target date funds. This article will help you understand what is happening in the bond market and what questions to ask in deciding the course of action that’s best for you and your portfolio.
What’s Happening in Bonds
Bond yields have jumped dramatically since May 2013, when the Federal Reserve announced that it might consider reducing the quantitative easing program by spring 2014. The term you may have heard in connection to this is “tapering”. This very tentative suggestion led to a broad sell-off in the bond market, which caused downward pressure on prices – and with bonds, when yields go up, prices go down. In just eight weeks, the yield on the 10-year Treasury Bond went from 1.62 percent to 2.6 percent! As of this writing, the 10-year is now at 2.789 percent.
Back in February, prior to rates going higher, I wrote a Warning article about precisely this issue and how to approach bond investing with future yield hikes in mind. Now that higher yields are here, it’s important to make a plan for the future.
This might not seem like much at first, but consider how much a 1 percent change in interest rates affects your views on something like a mortgage. In a recent Forbes article, it was noted that a 30 year fixed mortgage went from around a 3.35 percent to 4.51 percent. Suddenly that’s a pretty big difference, and many home buyers would agree: home sales fell by more than 13 percent between June and July.
Yield Changes and Your Portfolio: Bond Mutual Funds
You might be part of the large investor population that primarily invests in bonds through mutual funds. In this case, a sell-off can have a significant effect on your principal. Indeed, in June alone, worried investors withdrew a record $69 billion from bond mutual funds and ETFs. When trying to meet high investor redemptions, mutual funds almost always have to start selling holdings to generate cash. And when selling into a declining market, this unfortunately often means selling the best holdings, or those that are most liquid. It puts additional downward pressure on prices overall and negatively affects your principal, because those good holdings are no longer part of your portfolio. And remember, because you don’t own these bonds personally, but rather through a fund, you can’t just wait for the bonds to mature to get your principal back.
This is unfortunately one of the major drawbacks of bond mutual funds. The question is, how do you react to the current environment? Do you ride it out and hope to recoup your principal, or do you start diversifying out of bonds and into other asset classes? Or, if you rely on your fund for the income and not for the principal, do you keep calm and carry on?
In my opinion, and of course on a case-by-case basis, bond mutual funds can be okay if you are using non-leveraged, high quality, and short- to intermediate-term funds. Managers do matter, and I am a big proponent, when possible, of buying individual bonds actively managed by a professional rather than a stagnant laddered portfolio. To find out more about the benefits of active management, take a look at The Case for Active Bond Management.
Yield Changes and Your Portfolio: Individual Bonds
If you’re satisfied with the individual bonds in your portfolio and you intend to hold them to maturity, you might not be worrying about short term price changes, as you’ll continue to collect your coupon and a principal payment at the end of the bond’s life.
But what do you do with additional investment money to be allocated? What do you do with bonds that are close to maturity? Owning individual bonds can come with its own set of strategic questions that ultimately hinge on your beliefs about interest rates, the bond market, and investor behavior.
Taking the Next Step
It seems that the Fed’s hints about future plans have possibly broken the seal on interest rates, meaning that the market now believes rates will rise in the future (and when it comes to the market, these are often self-fulfilling prophecies). What to do really depends on what you and your advisor think, and about how these projections square with your individual investment strategy.
While bonds have historically been easy to incorporate into your portfolio, in this new environment I believe it’s a lot harder to get it right. I recommend rethinking your current and future allocations, and for my own clients I am carefully monitoring interest rates and the bond market. For example, I am constantly reviewing each client’s portfolio and may consider moving out of bonds and into other asset classes when we feel it is appropriate, as consistently increasing rates could put a drag on their portfolios.
If bonds have been your safe haven and you’re concerned about these price and interest rate shocks, you may decide to diversify into other investments. If you were to divest out of bonds and into other asset classes, my suggestion would be to diversify into several asset classes rather than just replacing your bond holdings with one other asset class. You may want to consider anything from US and international equities all the way to alternative investments. Take a look at my article about alternative investments and how they can help you reduce risk in your portfolio.
I strongly believe you should not chase yield, and therefore usually advise my clients not to use leveraged, lower-grade, longer-term bonds. Generally speaking, chasing yield can make you into your own worst enemy by significantly increasing the risk in your bond allocation, which might end up being counterproductive to your investment strategy. Instead, take a look at Institutional Investing for the Individual Investor for more advice on how to structure your portfolio like a professional investor.
Choosing a strategy
Whatever you do, do something: Get in touch with your advisor, discuss his or her analysis of the situation, and make a plan for your individual portfolio. You may decide that riding it out is the best thing for you, or you may decide to start allocating away from fixed income.
But whatever you do (even if it’s nothing!), having a plan is the most important thing, rather than ignoring the situation and waking up worried every day.
photo credit: HckySo via photopin cc
To learn about retirement savings, download 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
The views and opinions expressed in an article or column are the author’s own and not necessarily those of Cantella & Co., Inc. It was prepared for informational purposes only. It is not an official confirmation of terms. It is based on information generally available to the public from sources believed to be reliable but there is no guarantee that the facts cited in the foregoing material are accurate or complete.
Comments may not be representative of the experience of other investors. Investor comments and experiences are not indicative of future performance or results. Views and opinions expressed in the comments section are the author’s own and not those of Cantella & Co., Inc. No one posting a comment has been compensated for their opinions.