Protect Your Bond Portfolio from Rising Interest Rates

February 16, 2017
By Paul Jacobs, CFP

Many investors believe that infrastructure spending combined with more government borrowing will lead to a rise in inflation, and consequently, higher interests rates. This puts long-term bond investments at risk of losing money. Here are some ways of limiting that risk.

Bonds should provide ballast in a portfolio, but their risks must be managed. If rates go up significantly, you can lose a lot of money with long-term bonds.

President Trump’s formula for growth, coupling infrastructure spending and more government borrowing, is likely to cause higher inflation and lead to higher interest rates, most investors believe. If they’re right, what should you do?

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Keep investing in bonds via an all-weather portfolio that limits your risks but still gives you good current income and some upside potential.

Here are my recommendations.

Put the bulk in short-term funds.

Short-term, high-quality bond funds should form the core (about 50 percent) of your fixed-income portfolio. Such funds should maintain their value even if interest rates go up substantially.

Diversify by type.

Invest in corporate bonds, asset-backed securities, U.S. government bonds and tax-exempt municipal bonds (unless you’re in a low tax bracket). Diversifying by category plus regular rebalancing reduces risk and improves returns. Invest via funds, not individual bonds.

Invest a portion in intermediate-term bonds.

Consider investing a portion in intermediate-term bond funds. Their higher yields will generate higher returns if rates stay low or rise gradually. It’s important to hedge against the risk of rising rates, but it is also important to hedge against the risk of rates remaining low for the long term.

Add floating-rate bank-loan funds.

These funds have attractive yields. And they do well during periods of rising rates because rates on the underlying loans go up as market rates rise. Since these funds invest in lower-rated debt, do not invest more than about 15 percent of your bond portfolio in them.

Avoid all long-term bond funds and ETFs.

The modest extra yield isn’t worth the big extra risk.

Avoid foreign bonds.

Currency risk can outweigh higher yields on foreign bonds. If the dollar appreciates, that can quickly push foreign bond returns into negative territory.

Rationale Behind the Recommendations

The Federal Reserve controls only short-term rates. Markets control long-term rates. Sometimes the federal funds rate and long-term rates move in the same direction. Sometimes they don’t.

For instance, from June 2004 to June 2006, the Fed pushed the federal funds rate from 1 percent to 5.25 percent. Because investors widely expected the increases and the Fed communicated its plan ahead of time, the U.S. bond market remained calm throughout this period and provided positive returns. Longer-term interest rates rose only slightly during this time.

It shows that bond investors can still profit during periods of rising rates.

You can’t make a killing in bonds anymore. After 36 years of falling rates, it is mathematically impossible for bonds to provide the same level of big returns that they have since 1981.

Inflation could return. Seeing interest rates triple or quadruple may be hard to imagine, but it has happened before and it could happen again. If inflation starts climbing too fast, the Fed may have to raise rates more rapidly than it planned to.

Consider what is happening in bond markets around the world. In the last few years, negative interest rates took hold in many countries as foreign central banks pushed rates below zero in an attempt to further stimulate their economies. With trillions of dollars of global bonds now trading with negative yields, U.S. investors cannot ignore this phenomenon.

Negative rates do not appear likely in the U.S. anytime soon, and for now, it looks as though rates will rise, not drop. But if the U.S. experiences an economic recession before rates have a chance to rise significantly, it is possible that we could eventually see stimulus measures that include negative rates.

On the other hand, as U.S. interest rates rise, our debt will become more attractive to foreign investors, and many of them could pile into U.S. bonds, pushing yields back down again. Conversely, if foreign countries relax their stimulus efforts and allow interest rates to climb, the change should make it easier for U.S. rates to climb as well.

The bottom line: it’s tougher than ever to predict rates.

That’s why it’s crucial for investors to use their bond-fund portfolios to reduce risk and generate returns under any rate scenario.

Paul Jacobs, Certified Financial Planner (CFP), Enrolled Agent (EA) is chief investment officer of Palisades Hudson Financial Group, based in its Atlanta office.

Palisades Hudson Financial Group is a fee-only financial planning firm and investment manager based Fort Lauderdale, Florida, with more than $1.2 billion under management. It offers financial planning, wealth management, financial management and tax services. Branch offices are in Atlanta; Georgia; Austin, Texas; Portland, Oregon; and Stamford, Connecticut.

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