Winds of change in the bond market: Time to rethink
For more than three decades, the interest rates have been falling, and investors have had to deal with the zero Fed funds policy for the last six years. However, change is coming to the bond market, and that means it is time to rethink your strategies.
The Changes and How They Affect You
When the interest rate goes up, then price of bonds and bond funds naturally decreases. Bonds have a maturity date so the fluctuation in the prices will not matter, as you are protected from hikes in the interest rate. When the bond matures, you will receive the principle value.
Complexity of the bond market forced many people to invest fixed income portion of their investment portfolios in bond funds. As I said, when rates rise, bond prices drop, as well as price of bond funds. Furthermore, money withdrawal from the bond funds will force fund managers to sell bonds before maturity resulting capital loss for the funds. When withdrawal is completed and fresh capital is flowing into bond funds, managers will buy newer bonds with higher coupons.
Yes, you might have higher income distributions from the funds, however occurred capital losses will not be re-installed and funds prices will stay at much lower level than when you invested your money. You may never recover from your losses unless rate cycle is turning again. Once you decide to cash out your bond funds investments you face a real capital loss.
As this market is changing, it becomes very important to rethink the strategy of buying bond funds. Instead, it makes far more sense for investors to choose individual bonds rather than to continue with bond funds. Portfolio of individual bonds are immunized from risk of interest rates hikes.
Bonds tend to act in different ways when the interest rates start to rise. For example, a high yield bond will generally perform better than higher quality bonds when the interest rates increase. Choosing higher coupon payments can help to offset the decrease in price. Since the spread is narrowing though, it means that the ability to “cushion” the bonds will not have as much effect. Taking fewer risks than usual could be a much better strategy right now.
The goal should be to think about the return of the capital rather than the return on your capital. Taking more risks today will not actually help you to improve your returns simply because of the narrowness in the yield spread. The high quality and low quality bonds are too similar. Being more cautious can help you to reduce your risk, which is essential for any investor in the bond market currently.
Tips to Help
With all of the changes coming to the bond market, it is natural for many investors to feel a bit uncertain about what their move should be. The following are three simple and useful tips that can help.
• Stay with higher quality individual bonds
• Take premium bonds with high coupons
• Spread your money over a medium term bond ladder (three to five years)
Start rethinking your strategy now before it is too late.