It’s time to start thinking about New Year’s resolutions. It’s an American tradition to resolve to lose weight, exercise regularly, be nicer, work harder and give up everything you enjoy.
But who are we kidding? Such resolutions are made to be broken. So this year, why not make a resolution and keep it? This year, resolve to pay attention to bonds.
That’s right. Boring old bonds. They don’t have the flash that stocks do, they lack the immediate thrill that cash can provide because of its liquidity and they’re not as mysterious as alternatives. Yet, if you give them a chance, bonds can play a major role in ensuring that your retirement will be secure.
Bonds are not without risk – especially in a rising interest rate environment – but they can help you protect your principal, produce income and add to your total return.
For bonds to help you meet your financial goals, you need to plan carefully; especially in today’s investment environment. Given that markets are moving as a result of the Federal Reserve Board’s quantitative easing program, rather than market fundamentals, they are not following their historic pattern of moving in the opposite direction as stocks.
What To Do
Previously, bonds provided balance and diversification, creating downside protection when stock prices fell. Today, that’s not necessarily the case. So what should you do?
Pay attention to factors influencing bonds. Several factors will likely affect the performance of your bonds in 2014:
- Interest rates will likely increase modestly. With the official U-3 unemployment rate now at 7%, The Fed is likely to begin tapering its bond purchases within the next few months. As a result, Blackrock predicts the 10-year Treasury yield will climb a modest 0.5% by the end of 2014.
- The fed funds rate, which is that rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight, is expected to remain low, even as tapering begins. A sharp rise in rates would have negative economic consequences, so The Fed will move cautiously. The fed funds rate influences other rates, so if it rises, mortgage rates and other rates will increase.
- Inflation is at a four-year low and is likely to remain low through 2014, given the continued slow economic recovery.
Based on this economic environment, we recommend the following resolutions:
Shorten the duration of your portfolio. As we’ve previously pointed out, all bonds are not created equal. A corporate bond with a five-year duration will either appreciate or decline by 5% if interest rates increase or decrease by 1%, and a bond with a three-year duration will either appreciate or decline by 3% if interest rates increase or decrease by 1%.
By actively managing the duration of your bond portfolio, you will have an opportunity to reinvest bond proceeds at higher interest rates as bonds mature.
Pay attention to details. The type of bonds you own and their features will have an impact on the value of your portfolio. For example, if bonds in the portfolio have call features, they may skew the duration of your portfolio.
The call date acts as a buffer until rates rise above the coupon. If interest rates move higher, the bond’s call feature is no longer an attractive feature and the bond’s price will adjust from pricing at the callable date to its final maturity. This would cause the bond to convert from a short duration bond to a longer duration bond, which would affect its price.
It may also be a good idea to avoid Treasury Inflation Protected Securities (TIPS), which are designed to protect against loss of value caused by inflation. If inflation remains low, as expected, they will not be a good investment.
Conversely, bonds that trade based on credit or the ability of the issuer to pay back its obligations provide an opportunity to increase income with higher yields, in spite of lower interest rate sensitivity.
Don’t abandon bonds. A record amount of money left the bond market last summer after Fed Chairman Ben Bernanke announced that tapering might begin soon. It didn’t and, although interest rates began to rise, and it was premature for investors to abandon the bond market.
Rising interest rates may even create opportunities to purchase bonds at bargain prices.
In addition, as tapering takes place, bonds will increasingly be less affected by Fed action and will stop moving in the same direction as stocks. They will revert to their historical role in asset allocation of balancing your stock holdings.