It’s understandable that bond market investors might be frustrated at this point in time. Most already have lower total return expectations than stock market investors, which they accept in exchange for lower overall levels of risk and regular interest payments. However, the total return expectations within the bond market have become so low that investors are being forced to re-evaluate what they own and what they will buy going forward.
There has been one factor that has dominated the fixed income landscape over the past 30 years and created a nice tailwind for long-term bond investors: interest rates have been trending lower since the 1980s. But now that we’ve reached a point where rates can’t go much lower, many questions exist about how the bond market will fare in a rising interest rate environment. Along those lines, what can investors do now to cope with high bond prices and historically low yields? The “right decision” about bond investing will always depend on the specific investor’s overall objectives and tolerance for risk.
One option is to reduce the average duration of the bonds being purchased. If rates are expected to rise in the not-too-distant future, locking yourself in for 5 years instead of 20 years may be a wise move, even if you accept a lower interest rate on your bonds. Using this strategy, you’ll have the option of redistributing your principal into higher yielding bonds five years down the road, presumably at a time when rates will be higher than they are now. The rub with this strategy is that shorter dated bonds often have higher prices and/or lower yields than long dated bonds, so you’ll need to browse the market carefully to find your ideal duration with an acceptable yield. Fortunately, there are also exchange-traded funds (ETFs) that group bonds into indexes with shorter durations.
Another available strategy is to reduce the average quality of the bonds that one is purchasing. Yield and quality generally are inversely correlated, so buying a bond with a lower rating may produce an extra percentage point or two that can help compensate for the low rate environment. This strategy may require an investor to do a bit more homework when it comes to filtering through lower quality bonds to avoid anything too risky. As a general rule, higher bond yields often imply a higher risk of default, so doing careful research with your security selection is very important with bonds, just as it is with stocks. As with duration, there are several ETFs that categorize bonds into higher and lower quality, so this may be a way to incorporate lower quality bonds into your portfolio.
Some investors have even started to replace some portion of their bond portfolio with equities. This migration continues to happen as yields remain historically low and some people (specifically retirees) may need to generate higher returns to meet their financial goals. There are many high quality stocks that currently pay out substantially more each year than a 10-year Treasury note. If the investor does not need their principal back for many years, stock investing offers the potential for capital appreciation in addition to the dividend income.
Further, many people believe stocks can tolerate a rising interest rate environment better than bonds can. For example, if you buy a 20-year bond and rates subsequently start to rise, the price of your bond will likely decrease, leaving you “stuck” with that bond unless you’re willing to sell it for less than you paid. But while some of these potential advantages to investing in equities may be appealing to some fixed income investors, you’ll want to consider all the risks that are present within the stock market that may not be present within the bond market.
As with many portfolio issues, the right moves to make will depend on your personal situation. For some, buying lower quality bonds or dividend-paying equities may be the ideal fix for a low-rate environment. For those with a lower tolerance for risk, maintaining a larger cash balance while waiting for rates to tick up may be more appropriate. Taking some time to review your portfolio and your reasons for investing should help make these decisions a little easier.