By W.J. Rossi
The 10-year U.S. Treasury rate rose from a low of 1.41 percent in July 2012 to more than 2.9 percent this August. Because prices of bonds move inversely to rates, the results were seemingly catastrophic to the bond market. For almost 30 years, bond rates had experienced “tailwinds” from the fall of most interest rates since the heyday of inflation in the 1970s and 1980s. This recent rise in rates made many question the role of bonds as safe, income-generating investments in their investment portfolios. Many were probably even surprised to see that their bond portfolios had negative returns when they opened up their last quarterly statements.
Bonds, however, still have a place in most people’s investment portfolios for many reasons. First, bonds have historically been less volatile than stocks. The Barclays U.S. Aggregate Bond Index is a benchmark for the bond universe, and had a standard deviation of returns of 3.6 percent during the last 15 years; the S&P 500 had a standard deviation of 16.2 percent. Second, a bond held to maturity won’t suffer from immediate interest-rate risk. If you buy a bond and don’t sell it, but let it mature, you get the stated coupon payment, or interest rate, at the time you buy it. Third, bonds provide fixed income payments.
While the tailwinds of the past are now headwinds, bond investors can mitigate interest-rate risk. Here’s how:
· Hold cash. If you know you have a liquidity need in the next year or two, setting aside funds for the short-term mitigates interest-rate risk.
· Hold a mix of different types of bonds. Treasuries aren’t the only type of bond investment. There are high-yield bonds and mortgage-backed securities, for example, and many types of bonds that offer higher coupons (which help offset some of the negative impact of rising rates) than Treasuries.
· Reduce interest-rate risk. One way to reduce interest-rate risk is to hold securities with what is called low duration. By itself, duration is a measure of a bond’s price sensitivity to changes in interest rates.
· Consider a small allocation to income-producing stocks. Dividend stocks and master limited partnership investments provide an alternative to bonds. When rates rise, it is often due to improving economic conditions, which is good for stocks. Allocations to stocks should be small because stocks may be more volatile, especially in the short-term.
· Know thyself. Bonds have a place in a portfolio, but you need to know your financial goals, have a budget, know your risk tolerance, etc., to understand what your portfolio is designed to do. It’s about going back to basics about why you need bonds in the first place.
A trusted family member, friend or adviser with financial savvy can guide you through the process of how bonds fit in your investment portfolio.
W.J. Rossi is a Partner at Koss Olinger Financial Group where he began his financial services career in 1997 after earning Bachelor of Science degrees in Finance and Economics from the University of Florida. Soon after, he obtained both the Certified Financial Planner (CFP®) and Chartered Financial Consultant (ChFC) designations. Mr. Rossi’s areas of expertise are investment management, estate planning, and creating income distribution strategies during retirement. Rossi’s professional insights about investing and comprehensive planning, as is used in The Wealth Navigator System, have been quoted in national publications, including Money magazine. Additionally, Rossi has spoken at industry conferences such as Million Dollar Round Table’s Top of the Table. Contact W.J. at [email protected]