When Interest Rates Wake Up, Bond Exposure is Still Key

Normally bonds are the sleepy, steady part of the portfolio.

They are intended to provide stability, with their income acting as a ballast when equities get a little too wild. Well, since the election, sleepy interest rates have come out of hibernation, and now the Federal Reserve has responded this week with a small, but long-awaited increase to the federal funds rate. We wanted to explain what to make of the current bond and interest rate environment.

Rates are Rising—and That’s a Good Thing, Long-Term

When you invest in a bond or bond fund, you are lending money, and you expect a return for your investment in the form of interest. Unfortunately, we have been in such a long, prolonged period of low rates that savers have not received much reward for lending their money in terms of yield over the past decade. Bonds have still done their job of providing income, but there is far less of a cushion against equity volatility than there has been historically.

That dynamic is starting to change. The week after the election, reactive investors collectively pulled $9.1 billion out of bond funds and poured $25.4 billion into stock funds. This move was motivated by projections that U.S. economic growth and inflation will increase with Donald Trump’s fiscal plans and infrastructure spending agenda. The net outflow from bonds and into stocks continued throughout November, and has created a risk-on, rising-rate environment in the market.

This environment resulted in new highs for equities, but the mass selling of bonds after the election caused bond prices to go down, and yields to go up (these factors are inversely related). But over the long term, bondholders want higher rates. A higher rate environment signals a healthy economy and better income opportunities, both of which are positives for long term investors.

So even though bond prices have gone down in recent weeks, bond investors still receive income from their holdings. Think of it as if you owned a rental property, and the value of the building fell, but none of your tenants moved out. Even though the dollar value of the building has gone down, you still receive the income—which is the reason you own the rental property! You would not abandon a source of income because of a short-term change in value.

Fed Funds Rate Rose on Wednesday

The long-term benefit of rising rates is why the Federal Reserve finally raised the federal funds rate by 0.25% on Wednesday. (The federal funds rate is the overnight lending rate between large banks, which affects the bond market as well as interest rates for consumer and business lending.) After this change, the federal funds rate will still be extremely low (between 0.5% and 0.75%).

This move has been long awaited, and in fact, at the beginning of this year, up to four rate increases were expected. But as it has turned out, the Fed has acted similar to last year, when several rate increases were expected, yet only one actually occurred in December 2015. This recent increase is only the second increase in a decade.

The Fed has been very cautious in the timing of their rate increases, based on economic factors and unemployment statistics. The fact that they decided to move forward with the rate increase despite some recent bond volatility is a sign of their confidence that the market can absorb this change. Fed officials remarked they anticipate rates rising faster next year, targeting three increases in 2017, but this is dependent on the Fed’s discretion.

Never Fear, Diversification is Here

Rising rates have been expected for quite some time now, so we have prepared portfolios accordingly, by choosing less-interest-rate-sensitive holdings in each asset class of bonds. Our commitment to diversification also helps protect portfolios in this scenario. Since we use bond funds rather than individual bonds, the bond holdings are frequently re-shuffling to provide the most advantageous rates for their asset class.

Why Bonds are Still So Important

Regardless of short-term downside, bond exposure is still incredibly important to your overall portfolio allocation for the following reasons:

Bonds are not correlated with stocks: When equities soar, it is normal for bonds to underperform, and vice versa. You would not want a scenario where all of your holdings went up and down in tandem—diversification allows some parts of your portfolio to zig when others zag.
Diversification within bonds: We hold bonds funds of several different types. Each fund includes a basket of different bonds which mature at different times, so the basket reshuffles constantly and you get the advantage of some of the new higher-interest-paying bonds being added.
Downside protection: Remember that even your most volatile bond holdings are still going to have a lower risk-return profile than stocks. The stock market's worst ever 12- month return was a decline of 67.6% (S&P 90 Index, ended June 30, 1932). Bonds have had a much better downside profile, with the worst 12-month return a decline of 13.9% (Lehman Brothers U.S. Long Credit AA Index, ended September 30, 1974).

Bonds are for the patient investor, providing income and stability relative to stocks. We hope this explanation gives you a better understanding of current events in the bond market and how they may affect your individual portfolio! As always, we welcome your questions.

If you want even more detail about how bonds work…

Why do interest rates tend to have an inverse relationship with bond prices?—Investopedia

What is a bond? A way to get income and stability.—Vanguard

Bonds vs. bond funds—Fidelity

IMPORTANT DISCLOSURE INFORMATION

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