The prospect of rising interest rates, though not anticipated for the near future, has many bond holders wringing their hands. Their fears were stoked earlier this year by gurus like Warren Buffett who wrote that bonds are “the most dangerous of assets” because of their potential for eroding investors’ purchasing power.
But a fixed income strategist at Schwab offered strategies planners can use to avoid “bondageddon” and stay in the bond market, while protecting their clients’ assets.
“In our view, investors should manage their bond portfolios to mitigate the risk of rising rates, rather than abandoning the asset class altogether,” Kathy Jones, a Schwab vice president, writes here in her new report.
First off, Jones doesn’t anticipate any rate jumps until 2013 or 2014. However, she cautions, “longer-term bond yields have historically moved higher six to nine months before the Fed raises short-term rates for the first time in a cycle.”
It’s complicated to understand how to measure a bond’s “duration,” the measurement of its sensitivity to changes in interest rates. To simplify the process, Jones offers a rule of thumb for measuring the percentage change in a bond’s price given a 1% rise of fall in interest rates. For example, if you own a10-year bond, with a five-year duration, and interest rates decline 1%, you should expect it to gain 5% of its value. If rates move the same amount in the other direction, the bond’s value should decline 5%.
To prepare for a possible bump in interest rates, she offers the following strategies.
- Reduce the duration of your bond portfolio. Harvest gains. For income flexibility, consider bond ladders.
- Consider higher-coupon bonds. All else being equal, bonds that pay higher coupons (current income) are less volatile than bonds with lower coupons. Higher-coupon bonds generate more current cash flow that can be reinvested in a rising-rate environment.
- Decide on the amount of credit risk you're willing to take. Credit risk refers to the risk of default—the chance that you won't get your money back. One way to try to earn more income without taking more duration risk is to take more credit risk. Investment-grade corporate bonds (those rated BBB or above) usually yield more than Treasuries. However, credit quality varies depending on the sector and the issuer.
- Diversify globally. International bonds can also help provide diversification in a fixed income portfolio, because economic cycles aren't always in sync around the world. Allocating some portion of a portfolio to non-US bonds has historically created diversification benefits.
- Consider other types of bonds. Alternative bond structures such as floating-rate bonds or convertible bonds may make sense in a rising-rate environment. Coupon rates for floating-rate bonds are usually set to move up and down with an index, such as the London Interbank Offer Rate (LIBOR). Individual investors usually get access to floating-rate bonds through mutual funds. However, floating-rate bonds may come with greater credit risk than traditional corporate bonds, so it's wise to be cautious. In addition, many mutual funds use leverage in an attempt to boost returns, and if short-term rates rise, the leverage can reduce the fund's returns. Other options include convertible bonds and preferred securities.
“We believe it's prudent to make sure your portfolio isn't over-allocated to bonds—especially long-term bonds,” Jones writes. “However, we believe it would be ill-advised to ignore the potential benefits of diversification and income generation that bonds can provide in an overall portfolio."