Financial Advice Blog

What's a Bond Investor to Do Now?

by Community Manager  |  ‎11-18-2013 11:30 AM

Bond Indices - shutterstock_151894877.jpg

“Interest rates destined to spike, bonds will be crushed!”

OK … we’re not sure if anyone has actually said those exact words, but based on market headlines over the past few years, it’s certainly been a recurring theme. Shoot, we might even have said something similar a time or two! And despite the fact that it hasn’t happened yet — and might not — this isn’t alarmist thinking. Here’s why.

 

One of the ways the Federal Reserve has successfully kept interest rates near historic lows is by purchasing enormous quantities of bonds. Remember, interest rates and bond prices are inversely related. So, those low rates have helped prop up bond prices. You may have heard about this strategy in the news. It’s called “quantitative easing.” 

 

The concern this creates for many of us is that the Fed can’t keep buying bonds at this pace forever. Eventually, they have to slow down or stop and, eventually, the tide will turn for the bond market though these things might not happen at the same time. And when the tide does turn, bond investors are likely to feel some pain.

 

So as the title of this piece asks, what should you do with your bonds?

 

Don’t Panic
For starters, you should keep your eye on the markets and the headlines, but not to the point that it causes you to make a rash decision. Is it prudent to make some changes to your portfolio in light of possible market movements? Absolutely. But “some changes” probably does not equate to “radical changes.”

 

None of us — not the guy you saw on TV yesterday, not the woman who wrote the article you recently read, nobody — knows for sure what any particular segment of the investing world will do or exactly when it will happen. For example, it was just a few years ago that there was all sorts of public speculation about the possibility of the municipal bond market collapsing under the weight of a huge numbers of defaults. Guess what? Didn’t happen. Since we can’t know for sure what's going to happen, it’s usually prudent to build a plan, stick with the plan and then make minor adjustments and updates along the way.

 

Make Calculated Adjustments
In our work at USAA, we’re blessed to have access to the thinking of the really smart men and women who manage our investment portfolios and those of our members. (For real, it sometimes hurts our follically challenged heads when we talk to them.) Here’s what they think about this topic:

 

  • Long-term interest rates in the U.S. should gradually rise over the next two to three years.
  • The timing of this is difficult to predict so you should remain diversified.
  • If you’re over-allocated to bonds, you should consider making a modest shift from fixed income to equities, where suitable and appropriate.
  • Portfolios with substantial allocations to high-grade bonds might benefit by partially shifting some of these holdings to higher-yielding bonds as possible insulation against rising interest rates.
  • Shorter-duration, interest-sensitive bonds will generally be less affected by rising rates than longer-duration holdings. So where suitable and appropriate, it may be prudent to decrease the average duration of bond portfolios.

Some thoughts on suitability
You don’t have to scrutinize these thoughts too closely to see a recurring theme of suitability and appropriateness. This is intentional. Since we have no way to know your individual situation, we can’t just make a blanket statement that these points are something you should implement. Any changes you make should support achievement of your own goals and be in line with your risk tolerance and time horizon. We don’t want you losing sleep or taking next year’s vacation money and plopping it into something that’s could lose value! Again, the adjustments have to fit your needs.

 

As a couple of guys who started our careers as financial planners more than 20 years ago, do you know what we love about our team’s guidance? It’s not some fire-and-brimstone proclamation about things to come. Nor is it an arrogant assertion issued with unwarranted certainty.

 

Instead, in our minds, it’s thoughtful, educated guidance designed to help investors adjust to the current realities of the market and the economy. Is it guaranteed to be right? Of course not. Even with all of their education, tools, resources and experience, our team isn’t right about these things 100% of the time. Nobody’s team is. But we’ll take thoughtful and calculated over apocalyptic and alarmist any day.

 

 

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Additional Disclosures 

  • This material is for informational purposes and is not investment advice, an indicator of future performance, a solicitation, an offer to buy or sell, or a recommendation for any security. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing.  
  • Investing in securities products involves risk, including possible loss of principal.
  • Past performance is no guarantee of future results.  
  • As interest rates rise, existing bond prices fall. 
  • Some income may be subject to state or local taxes or the federal alternative minimum tax.

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Comments
by Investing Newbie ‎11-18-2013 07:49 PM
I was considering fixed-rate muni bonds as a higher-yielding secure alternative to CD's. After reading this, I'm not so sure that they are equivalent types of investments. Any thoughts on this?
by Community Manager ‎11-19-2013 09:06 AM

Thanks for the follow-up!

 

Municipal bonds and CDs are absolutely NOT equivalent types of investments. If you’re comparing CDs to individual insured municipal bonds held to maturity (as opposed to bond mutual funds), I could see how they might appear similar, but they really are vastly different approaches and are nowhere near equivalent to one another.

 

Now that’s not to say that muni bonds don’t make sense for your situation. I don’t have enough information to say one way or the other.  I’m simply pointing out that they are very different than CDs and typically would not be interchangeable products.  My suggestion would be to speak with an investment advisor or financial advisor about your portfolio and needs to see what might be right for your specific situation.  Thanks again for the follow up!  -Scott

by Investing Newbie ‎11-19-2013 10:34 PM
Thanks for the response! I was looking into buying one-year term insured muni bonds. I'm currently in a time zone that makes it very difficult to contact anyone in the states during business hours, so I've been trying to do everything online. I might be moving from active duty to the reserves soon, and I was just looking for a way to boost my emergency fund by investing in something with a fixed-rate and fixed-term. I'm looking at about $3000 that I can play with... I am hoping it will make more money than CD's and savings accounts, which can't be that hard to find...but also be guaranteed money back at maturity.
by Community Manager ‎11-20-2013 10:05 AM

My pleasure…happy to help!

 

I get where you’re coming from now and I completely appreciate your desire to boost your emergency fund returns. Even so, it’s important to keep the risk-reward (or even effort-reward) trade-offs in perspective.  With all short-term rates currently being so low, the real dollar difference you might earn over the course of a year in one product versus another is probably less than the money you currently have in your pocket.  Looked at that way, you may not find it worth the effort.

 

Plus, since you never know when you might need these funds, it’s important to keep your emergency cash liquid and available, even if you can’t earn much doing that.

 

Thanks again! -Scott