For the past decade, the Federal Reserve has kept interest rates low in a bid to support the economy—first by cutting a benchmark lending rate down to zero and then, when it couldn’t cut any further, adopting other rate-suppressing actions. Now that the end of this accommodative approach is at hand, bond investors face a dilemma. On one hand, investors will have to contend with falling bond prices as interest rates rise. On the other, higher interest rates will help them earn more income from their bond portfolios.
With rates poised to rise, now is a good time to review your bond portfolio to see whether it is positioned for changing conditions in the fixed income market.
The case for higher rates
The U.S. economy may be improving, but there are still potential weak spots in the labor market and inflation is hovering below the Fed’s long-term 2% target. So why raise rates at all?
First of all, it takes time for the full effects of changes in monetary policy to be felt in the economy. If the Fed waited until employment and inflation were both rising strongly before hiking rates, it could risk over-stimulating the economy. In addition, the Fed has expressed concern that leaving rates too low for too long could encourage excessive risk-taking by investors.
Finally, leaving benchmark rates near zero robs the central bank of one of its tools for influencing the economy. Adopting a more “normal” footing gives the Fed room to cut rates in the future if the economy needs a shot of stimulus.
The thing to keep in mind about the Fed is that it tends to move cautiously, and any rate increases in the months ahead will likely be “slow and low” compared to previous tightening cycles.
How will the market react?
So what might that mean for the bond market? Although no two economic or policy cycles are alike, Kathy says the previous three cycles of Fed tightening—1994, 1999 and 2004—could provide some guidance. Three things about these periods stand out:
- Volatility increased in the short term: The worst periods for bond market performance were generally the three months prior to and the three months after the first rate hike. Price declines for long-term bonds were greater than for short- and intermediate-term bonds during this time period.
- Long-term bond returns held up: In the one to two years following a rate increase, investing in long-term bonds delivered returns that were nearly as good as—or even better than—those from short- to intermediate-maturity bonds.
- Diversity was important: Holding a mix of maturities delivered returns with less volatility.
Given these findings, how might investors prepare their portfolios for a rising rate environment? Having a portfolio of diversified maturities is probably the best approach. Bond ladders and barbells are two strategies for spreading fixed income holdings across different maturities that can provide both flexibility and income.
With a ladder, you diversify your fixed income holdings across a variety of maturities. For example, a 10-year bond ladder would have some bonds maturing each year over the next decade. As bonds mature, you can reinvest the principal in new longer-term bonds. This is where the “ladder” comes in—every rung (or maturity) at the bottom of the bond ladder is replaced by one at the top.
The benefit of this approach is that you aren’t locked into a single maturity and have regular opportunities to reinvest. This can be helpful when rates are rising, as your maturing bonds will give you cash flow you can use to buy new bonds offering higher rates. The intermediate- and longer-term bonds will generate income in the meantime.
One of the potential challenges of building a bond ladder is that investors may need a relatively large portfolio to achieve diversification.
A barbell strategy basically divides the allocation of bonds between very short- and intermediate-term maturities in a bid to maximize the benefits of each. The short-term bonds provide liquidity that can be quickly reinvested in new bonds when rates rise, while the longer-term maturities provide income.
For investors sidelined with a high proportion of cash, waiting for interest rates to rise, a barbell strategy may be a good way to work into a bond ladder over time. As rates gradually rise, investors could add some intermediate-to-long-term bonds to the portfolio.
What to do now
The prospect of higher interest rates has investors both concerned about short-term volatility and hopeful about the opportunity to earn higher returns on their fixed income investments. It’s important to remember that bonds play a key role in your portfolio. They generate income, provide diversification from stocks and are useful for planning since most have fixed maturities. But when the Fed changes policy, fixed income investing can become more complicated.
Taking a few steps to diversify your fixed income holdings now could leave your portfolio better positioned to respond to shifting market conditions.