What Rising Interest Rates Mean for Your Bond Funds (Hint: It's Gonna Hurt)
Investors are pretty used to volatility when it comes to stocks. Bonds? Not so much.
That’s why the last little while has been an eye-opener for many. In the last three months, for instance, the Vanguard Long-Term Bond ETF has sunk 13% — hardly what you might expect from the supposedly stable, boring part of your portfolio.
So what exactly is going on here — and what, if anything, should investors be doing about it?
Basically the asset class is the definition of a “mixed bag” right now. “Bonds will almost assuredly underperform in the near term when interest rates rise,” says Matt Bacon, a financial planner in Gaithersburg, Md.
“But the increased rates tend to help the asset class over the long-term.”
To help understand what’s happening, consider this chain of events. Inflation has been ticking up, as we rebound from our pandemic-related economic slowdown. Morgan Stanley is predicting a peak around 2.6% in the spring, higher than we’ve been accustomed to in recent years.
That leads to the prospect of rising interest rates. The Federal Reserve typically looks at hiking rates to slow a rapidly heating economy, and prevent inflation from spiraling out of control.
Rising rates, in turn, would make the current menu of bonds, and their generally low yields, seem less attractive in comparison and affect their value. That explains why some investors have been rotating out
of long-term bond funds.
What rising rates mean for bonds
Before you go out and dump all your bonds, though, a few things to note. First is that the role of bonds in personal portfolios is to serve as ballast and counterweight to the equity portion. That role hasn’t changed, despite recent price fluctuations.
Second is that the Federal Reserve has been quite clear about wanting to keep rates low for the foreseeable future, which should ease your concerns about a high-rate environment. The consensus federal funds target rate for 2021 and 2022, according to panelists at FocusEconomics, remains a rock-bottom 0.25%.
Third is that a rising trendline for inflation is seen by most observers as a temporary situation, resulting from a reopening economy along with the recently passed fiscal stimulus. From the projected spring peak, Morgan Stanley sees inflation settling back down into the 2.3% range for the rest of 2021 and through 2022.
“Take a breath and don’t overreact,” says Jurrien Timmer, Director of Global Macro for Boston-based money managers Fidelity. “There are three things investors need to do: Have a plan, stick with that plan, and rebalance. Don’t sell something just because it’s going down, because it won’t go down forever.”
What to do about rising rates
That being said, there are a few modest portfolio tweaks you can undertake, if the bearish bond numbers are keeping you up at night.
Favor bond funds with shorter maturities. Yes, long-term bond funds have been taking it on the nose, but short-term baskets have not been nearly as affected. For example, the 6-month returns of the Vanguard Short-Term Bond ETF (BSV) are down only 1% -- hardly reason for panic.
“I've been using short-term investment grade and short-term high-yield bonds in our fixed income allocations,” says Justin Shure, an advisor with Endeavor Strategic Wealth in Aventura, Fla. “If an investor is looking at a bond fund, pay close attention to the duration. The higher the number, the more sensitive the price is to interest rates.”
Take the opportunity to rebalance. With the stock market at new highs, while some areas of the bond market have slumped, your asset allocation might have become out of whack. For example, a classic 60/40 portfolio of stocks and bonds might have lurched towards 65/35, says Fidelity’s Timmer. In that case, you could move closer to your target allocation by buying more bonds at this point -- presuming you have the stomach for that.
Look for TIPS. If you really are worried about inflation – and there is fair reason for that, since inflation is one of the most savage “portfolio killers” out there – well, there is an investment product for that. The value of Treasury Inflation-Protected Securities (TIPS) adjusts according to the level of the Consumer Price Index, which provides an added level of protection against inflationary pressures.
Consider silver linings — and ladders. Rising rates could certainly cause some near-term turmoil for bond markets. But for income-oriented investors, it’s not as if higher yields are a bad thing. In recent years, savers and bond investors have griped that there is hardly anywhere to generate decent income: If bonds start throwing off more cash, that could cause you to alter your portfolio strategy, perhaps with a laddering strategy as rates rise.
“For investors who are in retirement and seeking income from their nest egg, now is a great time to utilize a year-by-year bond ladder strategy to generate the income they need,” says Michael Peterson, a planner in Chambersburg, Pa. “Creating this ladder of individual bonds can protect your principal in a way that bond funds cannot. Bond funds are susceptible to lower returns and losses when interest rates rise. By using individual bonds, we can protect principal by holding them to maturity.”
Consider other income-generating assets. If a potential bear market in bonds is making you nervous, remember that there are other areas of the market that can produce income for your retirement years. Dividend-paying stocks are one, with many blue-chip names throwing off in the range of 3% a year — which compares quite favorably to the current 10-year Treasury offering of 1.6%. Real Estate Investment Trusts, or REITs, can be another key area for investors to find income.
Despite the recent swing in bond values, though, investors shouldn’t get too worked up about their fixed income. “In a way there’s a ‘Fed put’ in the bond market,” says Timmer. “If yields rise too quickly and for the wrong reasons, the Fed could take a more proactive stance on keeping rates low. That will put a floor under potential losses for bond investors.”
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