Have Your Bond Holdings Become Too Risky?

Have Your Bond Holdings Become Too Risky?

There has been much speculation recently as to when the Fed will raise interest rates.  The concern is that volatility in bond prices will spike and investors that have become used to bonds as a stable source of income will freak out.  If you haven’t started to worry about this, is now the time to begin?

No.

First of all, worrying doesn’t get you anything except a stomach ache and a reduction in your quality of life.  Who needs that?  A better approach is to understand what is likely to happen and to plan for it. I will try to address both briefly here.

Consider why you invest in bonds (or better still, in bond funds) in the first place.  If you’re not yet retired, it’s to bring down the overall risk of a well-diversified portfolio.  If you’re already retired, it’s not only for the diversification but also to generate a reasonably steady stream of income.  Unfortunately, bonds – even more than stocks – are sensitive to changes in interest rates.  When rates rise, bond prices drop, and vice-versa.  There are a number of attributes that determine the level of sensitivity a bond exhibits towards rate changes, and collectively they comprise what is called the bond’s duration.  Shorter-term bonds (those with durations less than five years) would be affected much less severely than longer-term bonds.  More specifically, a bond fund holding bonds with average ten-year duration will decrease in value by 10% if interest rates rise by one percentage point.  You can find measures of duration in a fund’s fact sheet or on Morningstar.com.

It follows that one good strategy in a rising rate environment is to invest in bond funds with shorter durations.  You will get lower returns while rates remain constant, but the prices of the funds will drop less when rates ramp up.  If your bond portfolio is heavily weighted towards longer-duration bond funds, replacing some of them with shorter-duration funds will reduce your portfolio’s overall duration and lower the risk of capital losses if/when rates rise.

If you are a retiree, this approach – which is focused more on protecting principal than on stretching for yield – may not provide as much income as your retirement plan calls for.  Nonetheless, in a recent research report on maximizing retirement income, Wade Pfau and Michael Kitces recommend keeping your bond risk low. They write, “When market valuations are high and stocks are exposed to an increased probability of low returns, the volatility of longer-term bonds can be a liability in mitigating sequence of return risk.”

Since shortening your bond durations results in lower risk but also in lower income, what can you do to boost the income if you’re dependent on your portfolio for living expenses?  One way is to diversify your bond funds themselves. There are numerous bond asset subclasses (e.g. municipal bonds, sovereign bonds, mortgage-backed securities), each with its own risk/return profile.  Some, such as Treasury Inflation-Protected Securities (TIPS), will increase in value when inflation heats up, potentially mitigating losses due to interest rate increases.  Others such as floating rate bonds require the borrower to pay more as interest rates increase, shielding the lender (you) from much of the losses.

You can alternatively follow a total return approach, in which the bond income is supplemented by capital from periodic liquidations of stock funds.  Or you can add alternative asset classes such as REITs and/or commodities to your overall portfolio.  Whatever approach you choose, I don’t recommend eliminating bonds from your portfolio simply because of the threat of rising interest rates. There are many ways to balance the risk and the return, just as there are in any economic environment, and that is what good investment management is really all about.

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