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We have been talking about interest rates with our clients at Glassman Wealth Services for years now, as historically low rates have retirees and those who rely on income from their portfolios yearning for yield.
So the expectation of higher interest rates for many investors like our clients is not a bad thing since rising interest rates will mean their long wait for higher yields is coming to an end. But traveling into higher interest rate territory can be treacherous and calls for some careful planning. So, what are the best bond investing strategies for today’s retirees?
Generally, the worst place to be when rates are rising is in bond funds or bonds with long maturities and low coupons since they will suffer the most as interest rates rise. Years’ worth of gains could be wiped out if rates jump quickly. Learn more about The Best Way to Invest in Bonds in a Rising Interest Rate Environment.
We have been focused on this risk now for some time and have migrated our portfolios away from longer maturity, lower yielding securities (investment grade). The general changes we’ve made include shortening the maturities of our core bond exposures while taking advantage of the higher yields available from the highest quality corporate junk bonds.
But there are different strategies that investors need to know about beyond the barbell investment approach that many of them take (meaning that they own bonds and cash on one end and stocks on the other). These strategies have the potential of providing risk and reward greater than bonds, but less than stocks. I like to call them The Stuff in Between.
Here are two of our ‘Stuff in Between’ strategies that we believe will hold up well in a rising interest rate environment:
1. Long-Short Bond Funds
Long-short bond funds look to invest in bonds and other fixed income investments while hedging against rising interest rates. We currently use two funds to accomplish this, Driehaus Active Income and Driehaus Select Credit.
For the past several years since the Fed all but flattened interest rates, retirees have had to make some tough choices. Invest in longer term bonds with a higher yield, but with more interest rate risk, or lower quality (junk bonds) with a higher yield, but more credit risk.
One example of a long-short bond strategy that Driehaus employs is buying longer-term corporate bonds to take advantage of the higher yields, and then taking a portion of the portfolio and shorting Treasuries to hedge against rising interest rates. If and when interest rates increase, their short Treasury positions will add some protection against falling bond prices.
Over time, we hope to see this investment achieve half of the return of stocks with 1/3 of its volatility; very much similar to what we expected from bonds a decade or two ago.
2. Short-Term High Yield Bonds
Lower quality companies issue bonds, also known as high yield or junk bonds that offer higher yields for investors who are willing to take more risk. But the risk experienced with these types of bonds can often be similar to that of stocks. Basic high yield bonds (junk bonds) may be just too volatile for many seeking yield. However, by shortening the duration of a higher yielding, corporate bond portfolio, risk is lowered to a more acceptable level for our clients.
We like the Osterweis Strategic Income Fund because it invests in short-term, high yield bonds with an average duration of two years. By investing in those bonds with short maturities, we reduce volatility, but still enjoy a better yield than we would get from bonds issued by higher quality companies.
We hope to achieve a 4% to 6% total annual return with ½ the risk of high yield bonds and 1/3 the risk of stocks with this strategy.
Interest rates are hard to predict. Even as many economists were expecting rates to rise, the 10-Year Treasury fell from 3.04% at the end of 2013 to 2.46% by the end of May this year. I’ve been known to say, “When everyone in the market expects one thing, the opposite often happens.”
That’s why we believe having a balanced approach to fixed income investing while including ‘The Stuff in Between’ will give retirees the best shot to achieve attractive yields and return with potentially less volatility – at least until the return of the 5% CD.
Would you like to learn more about our bond investment strategies? If so, please Contact Us.