Bonds are a familiar asset class to most investors, and, at Glassman Wealth Services, they are part of our clients’ portfolios. While bond funds have done well in the past few years fueled by declining interest rates, those times may be changing. With that shift, one of the questions most frequently asked by our clients is, “What is the best way to invest in bonds today?”
To better answer that question, first you need to know what bonds are and how they work. I’m always surprised at how many people really don’t understand the relationship of bond prices to interest rates. Put simply, the prices of bonds move in the opposite direction that interest rates do; i.e. interest rates go up, the price of bonds go down. Why? Because as interest rates go higher, new bonds will pay more than those that were offered earlier at a lower interest rate.
For a more comprehensive lesson in bonds and to get a better understanding of the types of bonds out there, see my CNBC article, Learning the ABC’s of Bonds.
Rising Interest Rates and their Impact on Bonds
A rising rate environment is not a bad thing. As long as it doesn’t happen in an abrupt, uncontrolled manner, it’s actually a good thing. Why? Rising interest rates allow investors who need income to reinvest principal that comes due from their bonds at higher rates.
Personally, I think more is being made of the individual risks in a bond bear market. What I am truly most concerned about is not rising rates, but about the potential behavior by bond investors. So much money has flowed into ‘bonds funds’ that if/when this money tries to move out in mass, it could cause a disruption in the liquidity and pricing for bond funds of all types. According to the J.P. Morgan’s Guide to the Markets as of 12-31-13, $925 billion has flowed into taxable bonds funds from 2009 to 2012.
Preparing for the Effect of Higher Interest Rates on Bonds
In a rising rate environment, bonds with the lowest coupons and longest maturities will most certainly decline in value. The most conservative thing investors can do is to shorten the maturities of the bond funds or individual bonds they own. This ensures that if/when rates rise that their bonds will not likely have lost much as prices decline, and this capital can be reinvested periodically into a higher rate environment.
At Glassman Wealth Services, we have been focused on this risk now for a couple of years and have migrated our portfolios away from longer maturity, lower yielding securities (investment grade) and into corporate bonds. In addition, we have been using long-short credit (bond) funds as another way to offset some of the inherent and potential risks to price declines when rates eventually rise in a sustained manner.
For older investors and retirees, my advice is not to overreach for yield in today’s environment. Stay shorter-duration, higher-quality for immediate (12 to 18 months) cash flow needs. Balance the rest of the bond portfolio thoughtfully with a combination of high-quality corporate, high-yield, and floating rate bonds, and perhaps, long-short credit funds.
The Benefits of a Bond Ladder
A bond ladder is a structure where you own individual bonds with (as an example) 25% of the bonds that mature in 1 year, 25% that mature in 2 years, 25% that mature in 3 years and 25% that mature in 4 years. The idea is that in each year as 25% of the bond ladder matures, this amount is reinvested in new 4-year bonds. If rates have increased, the yield on those ‘new’ 4 year bonds is likely to be much higher than the 4-year bonds that were purchased just one year ago. The benefit of a ladder is it brings balance and discipline to a bond portfolio, and it doesn’t require one to try and time the interest rate environment. As long as rates increase over time, a bond ladder ensures there is regularly available capital to reinvest at higher rates.
Rising rates are not the end of the world. In fact, if rates rise, this will increase the future income for savers and those with capital to reinvest at higher rates. That’s why knowing what you own – and why you own it – will be critical to your bond investing success now and into the future.
Do you believe that interest rates are headed higher? How are you preparing for a rising interest rate environment? I’d love to know what you think.