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Fed Rate-Hike Cycle: How Can Bond Investors Prepare?

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RANDY FREDERICK: As expected, the May Fed meeting came and went with no change in interest rates. Kathy Jones, Schwab’s chief fixed income strategist, joins me for the May 8 Schwab Market Snapshot to give us her views on the fixed income market and what it may mean for bond investors. Welcome back, Kathy.
 
KATHY JONES: Thanks for having me, Randy.
 
RANDY: So, Kathy, last week, the Fed passed on the opportunity to raise rates, and now, even though a June rate hike appears imminent, bond yields have actually come down a little bit. Can you please explain why that’s happened?
 
KATHY: Sure. What we’ve seen in the last couple of months is that economic growth has slowed down a little bit and inflation pressures have eased up, as well, and that’s really what drives longer-term bond yields. So even though the Fed has been raising rates, what we’ve seen is, you know, GDP growth in the first quarter was under 1%, significantly below the long-term trend, and we’ve seen a drop-off in commodity prices. Oil prices, steel, other goods’ prices have been falling, and that’s taken down the level of pressure on inflation. And all that has helped bond yields ease up about 25 basis points, or so, since the beginning of the year.
 
RANDY: Well, there seems like there’s a lot of reluctance and a lot of nervousness among investors. In fact, they’re very reluctant to buy bonds while the Fed is raising rates. But is that reluctance actually warranted?
 
KATHY: Well, you know, it’s interesting, because I understand the reasoning. We know that when interest rates go up, bond prices come down, so, naturally, if the Fed is raising rates people are fearful about holding bond investments. But it’s actually not unusual for bonds to rally as the Fed is hiking short-term interest rates. And, remember, the Fed influences short-term rates. Longer-term rates are influenced more by growth and inflation expectations.
 
So if we look back at, say, 2004 to 2006, the Fed was actually hiking interest rates aggressively. They raised rates 17 times and took the Fed Funds Rate from 1¼ to 5¼. And during that time, the total return for bond funds of various types—short-term, intermediate-term, long-term, and multi-sector, the Morningstar categories—actually all had positive returns. And a similar situation is occurring now. The Fed started raising rates in December 2015, and yet the total return for many bonds and bond funds is actually positive now.
 
RANDY: Well, given all those various factors, what should investors be doing right now?
 
KATHY: We think it makes sense to manage the duration in your portfolio and to match it up with when you need your money. So if you need your money in the very short-term, you know, keep it in a safe and liquid investment. But if it’s money you need somewhere down the road, several years from now, you may want to look at the short-to-intermediate-term, part of the yield curve. Because, right now, we think that that gives you the best balance of risk and return. So somewhere in the three- to five-year area, you get most of the yield that’s offered by the yield curve without having to take on the potential volatility of being in very long-term bonds. And then have a strategy that allows you to readjust as time goes by.
 
RANDY: Thank you so much for those great points, Kathy. Listen, you can read more from Kathy in the Insights and Fixed Income section of Schwab.com. You can follow Kathy on Twitter @KathyJones and, of course, you can follow me on Twitter @RandyAFrederick. We’ll be back again. Until next time, invest wisely. Own your tomorrow.
Important Disclosures
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. Please note that this content was created as of the specific date indicated and reflects the author’s views as of that date. It will be kept solely for historical purposes, and the author’s opinions may change, without notice, in reaction to shifting economic, market, business, and other conditions.
Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request.
Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.
Investing involves risk including loss of principal.

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