Bond Bull Breaking Soon?
The Dow Jones Newswires reported that bond fund inflows continued at their torrid pace through the month of September and stock funds continued to lose money from outflows over the month.
Investors seem to be coming to bond funds from two directions.
One set of investors looks to increase yield and is taking money from bank accounts and money market accounts. These days, bank accounts earn little, almost nothing. People are moving part of this money into short term bond funds seeking to gain at least one percent on their money without having to lock up the money into one or two year certificates of deposit.
The other set of investors seems to be selling their equity funds every time there is a bump up in the value of the S&P 500 or the Dow Jones Industrial Average. The thinking here seems to be that there has been some stock recovery and it is time to move into “safer” investments. September was a big month for the stock side of investing yet the outflows continued.
Other key fixed income investors are the people who need to generate steady income, paid monthly, quarterly or semi-annually. These are typically retirees, pension funds or people who have accumulated enough assets to not need to participate in savings and long-term investing.
All of these investors need to review the current interest rate environment, the past decade of bond returns and the potential for inflation.
Short term interest rates cannot go lower. The Federal Reserve has done their part to keep short term interest rates close to zero. That is the primary reason why your bank account does not pay you much in interest. They do not have to and do not want to. The banks have a hard time making money on the spread in rates between what they earn from short Treasuries and even the small interest rate paid to account holders.
Mid-range Treasuries also pay little. The 10-year treasury, considered by many to be the key “risk-free” rate, recently has averaged less than 2.5% in interest. Many investors use the 10-year as a gauge to determine whether they should move money from bonds to stocks or stocks to bonds. The 10 year over the last 20 years has been close to 5% on average.
Long rates are not much better and even here the Federal Reserve seeks to keep rates low. They have been buying long dated fixed income securities and their presence as a buyer has helped keep rates low there too.
So where can rates go? With any significant uptick in business activity, consumer demand and signs of inflation the Fed will begin to raise their short-term rates. They will stop buying long dated securities when they believe the economy has started on a course of growth (and most economists expect to see at least 2% growth in the US next year with more significant growth in emerging markets). History is on the side of rates going up in the near term.
Bond prices fall when interest rates go up. There has historically been an inverse relationship between bond prices and interest rates. Falling rates over the last year have led to gains in bond values. The longer bonds have done better as long rates have decreased. The opposite usually happens when rates rise.
Now is the time to review your options with your bond component. A gradual rise in interest rates can generally be handled by reinvesting dividends into the higher earning securities. A quick rise may look bad on your balance sheet but not have a real impact on your income and long-range plans.
Bonds play a key role in any portfolio. Income investors need bonds to be able to predict income. Long-term investors can profit with a bond component from the income as well. Bonds typically reduce volatility as bonds and stocks usually do not move up or down in tandem. Bad years in the bond market are usually less than bad years in the stock market. Investors with bonds outperformed the S&P 500 on average over the last decade.
Portfolios should be built on a plan and managed within a policy. The policy needs to have a clear idea of which assets classes to own and in what percentages. For instance, many endowments have used a 60%/40% stock/bond split. Long-term individual investors may have as much as 75% or 80% in stocks depending on their age, need for growth, risk tolerance and other factors.
Policies usually spell out maximum and minimum ranges that each section can contain. The stock piece in a 60/40 portfolio might be allowed to have a 70% maximum. After that, the portfolio is reviewed to make necessary changes to reduce risk and rebalance. We often make these changes as part of the annual review process.
Right now, we recommend reviewing the bond part of the portfolio to decide how to plan for rising rates. There may not be any action to take – especially for income driven investors who need to have current dividends continue. Others may decide to shorten maturities or hedge part of the portfolio. Others may decide inflation is years away and there is time to wait and see.
Still, it is worth taking the time to review your options and decide how we can help you plan for the likelihood of increasing rates over the next few years. We can look to have your portfolio suited to your individual circumstances, risk potential and planning needs.