How Should Bond Investors Anticipate Rising Interest Rates?

Investors know rates will rise but not when. In the meantime, how should you change your allocations?

 United States Federal Reserve Building in Washington, D.C.

The Fed is trying to prepare investors for rising rates to prevent a shock to the market, experts say.

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After the Federal Open Market Committee announced it cut $10 billion more from its quantitative easing program on June 18, stating that “underlying strength” in the economy shows the job market is improving, investors may be wondering what these developments mean for their bond portfolios. Minutes of a FOMC meeting held in June (released July 9) show the program is likely to end as soon as October, assuming the economy continues to grow.

The benchmark federal funds rate projected by the Fed will rise to 1.2 percent by the end of next year. That’s a small increase from the Fed’s projected rates in March of 1.125 percent.

Matt Jehn, managing partner at Royal Oak Financial Group, says The Fed is trying to gradually prepare investors for rising rates, citing the recent example of Federal Reserve Bank of St. Louis President James Bullard’s statements that the Fed may raise rates at the end of the first quarter of 2015. The market fell considerably after that statement but soon recovered.

“Every time they talk, the market drops. The Fed is going to walk us through this increase step by step, because if they did this abruptly, it would be a 20 percent to 30 percent fall in the market,” Jehn says.

After former Fed Chairman Ben Bernanke’s announcement in June 2013 that the Fed would cut back on quantitative easing in the middle of 2014, investors and fund managers went through a stage of panic and sold bonds. But the market has since accepted that interest rates will rise gradually, with some experts even pointing to complacency on Wall Street. Bond funds brought in $11.24 billion in May compared with just $7.47 billion in April, according to the Investment Company Institute. In May, however, 10-year Treasury yields reached their lowest level since June of last year.

[See: 7 Ways to Pay Less for Your Investments.]

Investors continue to buy bonds even as bond returns remain at historic lows. Since the relationship between bonds and interest rates is inverse, investors are concerned that the value of bonds will fall in the future. After 30 years, the bull market in bonds is finally over (rates simply can't go much lower), but financial industry experts say there are several options to mitigate the effects of a quantitative easing pullback.

Phil Blancato, chief executive officer and president of Ladenburg Thalmann, says he can see 3.25 percent interest rates in as soon as six months. Opinions differ widely on the issue of when rates will rise and by how much, however, with PIMCO founder Bill Gross stating in his June 2014 investor outlook that rates will stay close to zero for the foreseeable future.

Fed Chair Janet Yellen has stated that interest-rate movement depends on a variety of economic factors, but she repeatedly mentions the primary two as inflation and the labor market. In her July 2 remarks at the International Monetary Fund, she said monetary policy as a tool to prevent bubbles has "significant limitations." However, she hedged her statement by saying, "I’ve not taken monetary policy totally off the table as a measure to be used when financial excesses are happening."

Although the Fed seems optimistic that inflation will remain below the 2 percent target, financial industry experts have been widely skeptical, including Dan Heckman, senior fixed-income strategist at U.S. Bank Wealth Management.

"We think there is perhaps more inflation than she gives the market credit for. It very well could be a signal that they would allow inflation and move above their target," Heckman says. "It could simply mean the Fed will let that happen before a federal funds rate increase."

As longer-duration U.S. bonds become less appealing, floating-rate notes, non-U.S. bonds, the Treasury's inflation-protected securities and bonds with a duration of two years or less have garnered more attention.

Floating-rate notes and global multisector bonds have become popular as investors look for ways to diversify their bond portfolios and protect themselves from rising rates. Data and analytics service eVestment reported that floating-rate, bank-loan fixed income is expected to gain $20 billion in net inflows over the next four quarters, and global multisector bond funds have seen inflows of $30 billion since January. 

Larry Solomon, a registered investment advisor based in McLean, Virginia, is one of many financial advisors telling clients to diversify with these investments, as well as higher-yielding municipal bond funds such as iShares National AMT Free Muni Bond ETF, which has a mix of short-, intermediate- and long-term bonds and yields 2.9 percent. 

Solomon recommends Vanguard Total International Bond ETF because it has low expenses at 0.20 percent and hedges currency exposure. He also argues for the extra yield its non-U.S. bonds provide. The fund's one-year return through July 10 is 5.37 percent.

[Read: Emerging Markets: Investing in India.]

“Other countries’ levels of interest rates and inflation, the two most important drivers of bond returns, have had low and varied correlations with U.S. levels since 1990. The earlier sell-off in developed and emerging markets' international debt pushed yield in those sectors above 5 percent,” Solomon says.

Because floating-rate notes are less affected by rate increases, they have become popular ways to “protect” against future rate hikes. Solomon says investors should be more conservative and choose a fund like T. Rowe Price Floating Rate Fund, which boasts higher credit quality. It has a year-to-date return of 2.07 percent as of July 10 and is composed of 86 percent domestic bonds and 13 percent foreign bonds, with an additional 2.8 percent in cash.

Blancato says a good rule for investing amid interest-rate uncertainty is to make sure your portfolio’s overall duration isn’t over five years. Investors should invest in a mix of seven-year to two-year duration bonds to diversify and not necessarily invest in all four-year or five-year duration bonds.

[Read: The Pros and Cons of Bonds.]

“When reallocating funds, I think it’s logical to keep your overall portfolio duration south of four or five years. There is too much uncertainty, but once the taper is over, there may be some opportunity to add 10- to 15-year and long-term bonds,” Blancato says.

Your age should also factor into your bond portfolio. Jehn counsels his baby boomer clients to focus on shorter-duration bonds of two years or less. “The idea is if you buy in two-year bonds, at least we have the opportunity to make some game-time calls and allocate accordingly,” Jehn says.

He recommends younger investors simply buy longer-term bonds and invest in the stock market and emerging markets. “Someone in their 20s just needs to be diversified and ride it out,” Jehn says. “Right now, the only yield you can get is in the stock market.”

Investors shouldn't reach for yield in any interest-rate environment, since bonds are meant to serve as the ballast for stocks in your portfolio, says Jonathan K. Duong, a chartered financial analyst, certified financial planner and president and founder of Wealth Engineers LLC, a national registered investment advisor firm.

"Most investors would be wise to keep the bond side of their portfolio of the highest quality and of a duration of five years or less," Duong says. "Investors with more stock-heavy portfolios might consider extending a bit further out on the curve since the equities in the portfolio will dominate the volatility of the bonds."

He cautions younger investors against investing too heavily in TIPS because they don't rely on portfolios for income and their paychecks already increase with inflation.

"On the other hand, near-retirees or retirees are at much greater risk of unexpected inflation. For that reason, they should strongly consider a healthy dose of TIPS in their bond portfolio," Duong says.