RANDY FREDERICK: Once again, the Fed passed on the opportunity to raise rates at the September meeting, but there are still two more opportunities. Kathy Jones, Schwab’s chief fixed income strategist, joins me for the October 4 Schwab Market Snapshot to discuss why she believes bond yields are likely to rise between now and year-end. Welcome back, Kathy.
KATHY JONES: Thanks for having me, Randy.
RANDY: So, Kathy, we know the odds of a Fed rate hike before the election are very low. But you’ve been warning that bond yields are likely to rise anyway, even though a rate hike is unlikely until mid-December. So what forces are in play right now that could push yields higher sooner than that?
KATHY: Well, there are two forces we’re keeping an eye on, and one is just inflation. It’s been rising over the past year or so, and by many measures, it’s already above the Fed’s 2% target level. And a lot of this has to do with the stabilization in oil prices. When they were falling, that was putting downward pressure on inflation, and now that they’re more stable and kind of in a range, that’s allowing inflation to bubble up. The second factor is the policies of other central banks. So what we’ve seen over the past couple of months is that the European Central Bank and the Bank of Japan have actually pulled back from the policies of pushing their short-term rates ever into more negative territory. And the Bank of Japan is actually targeting higher bond yields because the low or even negative bond yields there have been really a problem for the banks, in pension funds, insurance companies and any long-term saver. So the combination of those two factors seems to be allowing rates to rise. We’ve seen—as Japan has pulled back from their policy stance, allowing long-term yields to rise—we’ve seen other markets see their bond yields move up, as well.
RANDY: Well, that makes a lot of sense, but rising yields are not necessarily a bad thing for investors who have been searching for portfolio income. For existing bondholders, however, it could be problematic, so what do they need to watch out for?
KATHY: Well, whenever you start to see interest rates rising, the major thing to focus on: duration of your bonds. And duration is a measure of risk, and what happens is the higher the duration, the more the price of the bond will change when interest rates change. So if you have a high-duration bond and interest rates go up, the price of that’s going to fall much more than it would for a low-duration bond. But just because a bond is low in duration doesn’t mean it’s low in risk. It could also have credit risk, meaning there’s a higher risk of default or that the issuer could miss a coupon payment. And oftentimes riskier bonds, like high-yield or emerging market bonds will also decline when treasury yields go up. So you have to watch both duration risk and credit risk in your portfolio.
RANDY: Well, certainly, even a quarter-point rate hike could have a negative impact on bond prices. So what suggestions do you have to help investors deal with bond market volatility and help reduce their portfolio risk in the coming months?
KATHY: The first thing to do is get a handle on how your portfolio is positioned. If you’re positioned in such a way that when rates go up you have the opportunity, and invest the principal and interest and earn more income, you may not need to do much of anything. But if you have a lot of high-duration bonds or a lot of low-credit-quality bonds, you may want to trim that back a bit. Or maybe consider an allocation to TIPS, which are Treasury Inflation-Protected Securities—they tend to do well when inflation rises—or, perhaps, investment-grade floating rate notes. Those are the type of bonds that the income will adjust up when short-term interest rates rise. But most of all, I want to point out that your financial consultant or your regional bond specialist can be really helpful. They can analyze your fixed income portfolio and your bond holdings, and help keep you on track with your financial plan.
RANDY: Thank you, Kathy, as always, for that expert advice. Listen, if you have questions, please call and talk to a Schwab financial professional. You can read more from Kathy in the Fixed Income and Insights and Ideas section of Schwab.com. You can always follow Kathy on Twitter @KathyJones. You can follow me on Twitter @RandyAFrederick. We’ll be back again. Until next time, invest wisely. Own your tomorrow.