Re-Thinking Your Bond Strategy In the Face of Rising Interest Rates

The stock market has been on a bit of a roller coaster lately, with the S&P 500 experiencing a pullback of more than 5 percent between May 21 to June 24 before bouncing back over the next few trading days.

But in a rare turn of events, it’s not the S&P or the Dow Jones Industrial Average that have commanded the attention of financial journalists and market observers. Instead, it’s the Barclays Aggregate and other bond market activity indicators. In fact, for the second quarter, the S&P has remained in positive territory, with a total return just around 3%, even with the May-June pullback. But the Barclays US Bond Aggregate is down more than 2% for the same period. Is it a bad idea to be in bonds?

Risk and Return

If you’re risk profile is conservative to moderate, or if your portfolio goal is more centered on income than growth, then it’s hard to avoid bonds. Bonds and other fixed income investments are meant to provide a stable, predictable income stream with little variance around the timing or the magnitude of each payment.

The volatility of bonds, as measured by standard deviation or a similar metric, is generally much lower than that of equities or commodities. As a result, bonds have long been seen as a necessary for managing overall portfolio risk. While there are some other types of assets that offer similarly low levels of volatility, they are not easy substitutes for bonds.

Interest rate risk is related to the effect of rising interest rates on bond prices; when rates rise, prices fall. The longer time your bonds have to maturity, the more susceptible they are to interest rate risk. That’s the big concern in the market now, with interest rates starting to rise from their historically low levels as the Federal Reserve considers winding down the monetary easing measures that have kept rates so low for so long.

It’s important to note that interest rate risk affects the market value of bonds. When rates rise, you can expect to see paper losses in your portfolio. But your income stream isn’t affected as long as you hold the bond. You get the promised coupon each payment period and the full principal upon maturity (unless the issuer defaults, which is not a matter interest rate risk but of credit quality risk).

Momentum and Fundamentals

The run-up in bond yields over the past month has been dramatic – and, in the opinion of many observers, overblown. These observers note that the Fed has not made any explicit commitments as to when they will start reducing stimulus measures, nor has the Fed said anything definitive about actually raising interest rates.

But fundamentals alone don’t move markets. Investor behavior has an effect, too. When large numbers of investors sell out of bond funds, as has been happening lately, the fund managers who operate those funds need to sell the bond holdings in the funds to redeem the investors who are getting out. That drives prices down further, and that in turn encourages more investors to get out of their bond funds. It can be a nasty chain reaction until things finally settle down.

Bonds are not going away as an asset class, and they will continue to be an important piece of a diversified portfolio. In a rising interest rate environment, the key is to allocate among bonds with shorter durations (and therefore less exposure to rate fluctuations) and/or low correlation to benchmark areas like Treasuries.

Do you think your portfolio has too high a bond exposure? Tell us what you think.