Wall Street's Best Minds
What’s a Bond Investor to Do in a Bearish 2017?
Charles Schwab analyst discusses ways to mitigate the impact of rising volatility and higher interest rates.
By Kathy A. Jones
Bond yields have spiked since last summer, raising concerns about a long-term bear market.
But declaring a bear market for bonds is more challenging than it is for stocks.
These policy changes could arrive during a period of near full employment and rising wages.
In each cycle, the yield curve peaked before the Fed finished hiking short-term rates, though the timing of the peak varied. In the 1990s, the yield curve peak occurred several months after the Fed began to raise short-term rates, while in the more recent cycle, the peak was much earlier.
She may have sold the bond at a loss somewhere along the way. However, a different strategy with shorter duration and the flexibility to reinvest could have produced better results.
First, reduce the duration in your portfolio. Bonds with shorter durations tend to be less volatile when interest rates move up (a Schwab bond specialist can help you determine the duration of your bonds or fixed income holdings). To estimate the impact of rising rates on a bond, look at the bond’s duration. A bond with a duration of five years typically will move down in price by about 5% for every 100-basis-point increase in interest rates. A bond with a 2-year duration typically will move down by about 2%.
You might want to consider adding floating rate notes that tend to benefit from an increase in short-term interest rates; however, they usually carry lower yields than fixed notes of the same maturity.
Second, look carefully at credit quality. A growing economy is often good for corporate bonds because company earnings and ability to pay interest expenses are improved. However, there isn’t a set pattern for the behavior of credit during cycles of rising interest rates. We believe it makes sense to be somewhat cautious because valuations are on the high end of historical averages.
Finally, try to focus on your financial plan and the reasons that you hold fixed income investments. For example, they can be a counterbalance to riskier investments like stocks, and can help you manage volatility over time. Fixed income investments also can provide steady, predictable cash flows, making them a useful source of income in a portfolio.
Jones is chief fixed income strategist at the Schwab Center for Financial Research, a unit of Charles Schwab & Co.
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