In the vernacular of NASA, we have lift-off. The Federal Reserve has raised the target federal funds rate for the first time in nine years. While the rise is small at just 0.25%—and the expectation is that future increases will also be modest—this shift has plenty of repercussions for income investors.
So is your current bond strategy suitable for the new rate environment, or is it time to make changes? Kathy Jones, senior vice president and fixed income strategist at the Schwab Center for Financial Research, offers suggestions for different bond-investing scenarios in light of the new interest rate environment.
Keep things in context
The first order of business is to maintain an even keel during the change. Yes, bond prices fall when bond yields rise, but Kathy thinks that the ingredients are still in place for a “low and slow” shift in rates, which should help mitigate the pain of price declines.
For example, according to Bloomberg data, the markets are anticipating that a two-year Treasury note (which recently yielded 0.7%) will not reach a yield of 2% until late 2018. Meanwhile, if you’re holding notes or bonds, you’ll likely be able to invest the interest income at higher rates.
Besides, history suggests that total returns—the combination of price changes plus yield—are unlikely to take a major hit for portfolios of intermediate-term, investment-grade corporate and municipal bonds as well as U.S. Treasuries (also known as “core” portfolios). In fact, during the worst bond bear market in history—from the mid-1950s to the early 1980s—there were still only a handful of years in which the total return on intermediate-term U.S. government bonds was negative. The worst decline was just 1.3%.
So the rate hike isn’t cause for panic, but your particular fixed income situation will dictate what changes might be in order. Here are Kathy’s suggestions.
Scenario #1: You’re sitting it out in cash
Now your cash investments can start to earn more, but at a low-and-slow pace it could be years before those investments earn anything close to the rate of inflation. Kathy suggests thinking about beginning to shift some cash into intermediate-term bonds or funds.
That means: Consider taxable bonds with durations in the five- to seven-year range, and think seven to 12 years for municipal bond investments. Why intermediate-term bonds? Because they tend to have higher yields than short-term bonds, with less interest-rate sensitivity than long-term bonds.
Scenario #2: You’re playing defense with short-term bonds
The federal funds rate has the most impact on short-term interest rates, which means you’re now officially in the Fed’s crosshairs. While prices may not decline much, you’re also not earning much in the way of interest. Kathy suggests a better way to keep it short: Own cash investments and intermediate-term bonds. That essentially nets out to a short-term strategy, without being directly invested in the short end of the market.
Scenario #3: You’ve taken the middle road with a core bond portfolio
“If your goal is diversification and capital preservation, I’m not sure you need to do anything,” says Kathy. The ballast provided by a core portfolio—which, remember, is intermediate-term, investment-grade bonds—is even more valuable with the equity bull market now in its seventh year. Price declines for a core bond portfolio with an average duration of five or so years (seven to 12 for muni bonds) should be moderate, and within a few years your rising income payouts may push your total returns back into positive territory.
Scenario #4: You turned to high-yield equities
If you ventured into higher-risk income investments such as master limited partnerships (MLPs) and real estate investment trusts (REITs), you might shift your focus to more traditional income generators like core U.S. bonds. As the yields on standard bonds become more competitive when rates rise, the performance of high-yield equities often suffers.
Scenario #5: You’re relying on longer-term bonds of 15 years or more
Many retirees have built portfolios of high-quality long-term municipal bonds to generate income. And long bonds first purchased eight or 10 years ago can have coupons of 4% to 5% or more, well above what newer bonds pay.
If you are focused on yield and don’t expect that you’ll need to sell the bonds before maturity, you may not have to do anything. But if you are concerned about price volatility, consider sticking with your target allocation to longer bonds while increasing your cash allocation. That will help reduce the overall volatility of your portfolio but allow you to keep cashing higher-interest checks from your long-term bonds. Another option to consider: Reinvest the income from your longer-term bonds into intermediate-duration bonds.
One key tip from Kathy: If you bought an AA bond five to 10 years ago, it’s smart to make sure that the issuer still has a high credit rating. If not, consider an upgrade.
While the first Fed rate hike in years rings in a new environment for bond investors, Kathy stresses that for a well-diversified portfolio emphasizing quality bonds, the shift isn’t bad news.
“Investors hungering for yield won’t have to go quite so far out on a limb to get higher payouts. That’s a good thing.”
What you can do next
- Call 877-566-7982 to talk with a Schwab Fixed Income Specialist about how you’re positioned for the new interest-rate environment.