By Mark Rylance, CFP®, CFT ™
“What is going on with the bond market?”
We have fielded this question from several clients recently. And, it is an understandable concern given the rising interest rate environment that we have witnessed over the last few years. We are also seeing some negative performance in bond prices for the first time in a while.
However, before answering the question of whether to sell your bonds, let’s first review why we have bonds in your portfolio.
Bonds play two specific roles: 1) to provide a predictable income stream, and 2) to provide an asset that moves in the opposite direction of the stock market, reducing volatility when stocks prices decline. If this is the purpose of bonds, then we should continue to hold them given the relatively low risk with respect to the expected return.
Now let’s quickly dissect the differences in bonds, because not all bonds are created equal. The main drivers of bond risk and return are duration and credit quality. Let me explain.
Duration is a measure of a bond’s sensitivity to changes in interest rates. For a rising interest rate environment, the rule of thumb is: if the interest rates go up by 1%, the bond could go down in value by the 1% times its duration. Put another way, if your average duration (think maturity) is 10 years, then the value of the bonds could go down by as much as 10%.
When it comes to credit quality, you want to own bonds with high ratings (high credit quality) when the stock market is experiencing volatility. This is because of the “flight to quality” which occurs as people jump from risky assets to safer ones. In the past, the safest investment during a stock downturn has been the 30-year treasury. However, this investment could prove to be a disaster in a rising interest rate environment since long-term bonds go down in value the most as interest rates rise. To balance these risks, we have made the decision to advise selecting high-quality, short-term bonds – protecting you in both situations.
It’s important to remember that we shouldn’t necessarily be afraid of rising rates. In fact, we should applaud them. If you are a net saver or retired on a fixed income, then rising interest rates are advantageous because rising rates can provide a higher predictable income in the future. (Note: If you are a net debtor, then the opposite is true. In this scenario, lower interest rates would allow for you to more easily afford your debt payments.)
We recommend our clients remember news headlines are structured to get viewers, even at the cost of creating anxiety where it shouldn’t exist. Yes, interest rates are heading higher, but the story line should be the opposite of what we are reading. The news pundits should be pointing out that for the first time in nearly a decade, the economy is doing well. Wages and company profits are rising and stable. Interest rates are increasing and adjusting to this positive activity, reversing a long-term trend of pessimism.
However, even with this good news, we are still being careful with your investments because they do not move in lockstep with the economic data. Stocks and bonds can go down in value in the middle of an expansion.
The moral of the story is that we are keeping your bonds in place because their two primary roles (consistent income and negative correlation) are still critically important today. At the same time, we are limiting duration and increasing credit quality.