Six years after the Federal Reserve cut benchmark rates to
nearly zero, investors have every reason to believe yields will indeed rise. It
is unclear when Fed Chairwoman Janet Yellen might press the button to
begin lifting rates back to more-normal levels. But any upward move in yields
can really hurt a bond portfolio; when yields rise, the price of a fixed-rate
bond drops.
With so much uncertainty facing the market, investors are
better off diversifying their bond portfolio to shield it from the multiple
things that could go wrong. People whose only bondholdings are in a 401(k) plan
often have fewer types of fixed-income funds to choose from, so it could be
harder to diversify. But especially for people approaching retirement, it might
be worth shifting some of a 401(k)’s bond position into a money-market or
stable-value fund, which wouldn’t be hurt by rising rates.
Those who own bond funds or exchange-traded funds in a
taxable account have many options. They should use them to spread their money
among bonds with various maturities and credit ratings, possibly through
several different mutual funds or ETFs. Here are some things investors should
consider in broadening their bond strategy:
A Clouded Outlook for
Yields
The latest market thinking, after Friday’s strong jobs
report, is that the Fed might start lifting lending rates around mid-2015,
raising them by as much as a half percentage point through the end of the year.
That would hurt shorter maturities out to around six years.
Longer bonds aren’t directly affected by Fed policy moves,
although they would benefit from a perception that the Fed is ahead of the
curve in containing inflation.
The Short-Only Risks
It isn’t a bad idea for investors to have some of their
holdings in short maturities, traditionally the steadiest part of the market.
But they could lose a little money there once the Fed finally moves on rates.
That is because short-term yields—currently about a half percentage point for
two-year Treasurys—are too slim to provide a cushion against the impact of a
Fed rate increase.
If an investor owned a fund with an average maturity of
around two to three years and yields broadly rose by a half percentage point,
that fund would shed nearly 1% of its value before interest received, says
Steven Huber, who manages T. Rowe Price Strategic Income Fund .
If investors have put money that they will need within two
years into such a fund, they would be better off moving it into an insured
online bank account, where they might get a rate of around 0.75% or more. If an
investor’s investment horizon is longer, the income they will get on a
short-term bond fund or ETF eventually should make up for any drop in principal
value.
Get Yield With Better
Diversification
A popular way to get good yields is owning a fund that
focuses on lower-rated, “high-yield” corporate bonds, also known as junk bonds.
Those currently yield around 5% to 6%, several percentage points above
investment-grade issues. Companies that issue them must pay more in yield to
compensate investors for the greater risk of default.
Higher yields provide a better cushion against rising rates.
The problem is, such bonds also trade in sync with stocks. So if a fixed-income
portfolio contained only high-yield bonds and stocks were to fall sharply,
stock and bond holdings could both lose considerable value.
But investors could smooth the ride and still get attractive
returns by pairing a high-yield fund with one that owns a good portion of
Treasurys or other highly rated bonds.
To Add Inflation
Insurance—or Not
Whether investors need insurance against higher inflation is
a matter of debate in the markets. Many bond strategists believe that with the
U.S. labor market recovering slowly and overseas economies weak, there is
little risk of an inflation flare-up soon. Still, bonds are sensitive to any
signs that inflation is reigniting, and it doesn’t take much of a rise to spook
the market. The best time to buy inflation insurance might be now, when it is
cheap.
It is important to understand that long-maturity Treasury
inflation-protected securities, or TIPS, have a lot of rate sensitivity. So
those bonds—and funds that own them—can be volatile. But the Treasury also
issues TIPS in five-year maturities. Morningstar’s Ms. Benz suggests that
investors stick with shorter maturities unless they have an investment horizon
of at least five years. Owning some TIPS could be particularly good for people
who are drawing down their portfolios for living expenses and need to worry
about preserving purchasing power.
Tread Carefully in
Floating-Rate Funds
Funds that invest in floating-rate debt securities—also
called bank-loan or senior-loan funds—have found demand among those worried
about the impact of rising yields. Such corporate loans are pegged to a
variable interest-rate benchmark such as the London interbank offered rate, or
Libor, and don’t lose value when rates rise. Instead, the rates they pay move
higher.
But they can have disadvantages. Because of the way many
loans are structured, their adjustable yields won’t move up until rates rise by
a certain amount, as specified in a loan’s terms. Also, the loans generally are
rated below investment grade, posing a similar level of credit risk to
high-yield bonds.
By taking less risk in some parts of their bond portfolio,
investors could improve their chances of getting the market right in 2015—and
beyond.
Click
here to access the full article on The Wall Street Journal.