Be patient holding bonds as rates rise
Joel Dresang: Steve, we know that the value of bonds tends to fall as interest rates rise. And we’re in a period now where interest rates have been rising. We expect them to continue to rise. So remind investors why they need to continue to hold bonds.
Steve Giles: Well Joel, bonds provide a level of stability and a lot less volatility for investors when held in a diversified portfolio. Bonds also provide a place for investors to go for withdrawals if the stock market sells off. And finally, I think it’s worth pointing out that when you do have opportunities of stock market sell-off, it’s nice to know you’ve got something that’s not in the market to use as dry powder, if you will, to take advantage of those opportunities, and that’s where bonds come in.
Joel: In the first quarter of 2018, bonds broadly declined in total return. What do you say to investors who see that as the safer part of their investment portfolio?
Steve: Joel, I think it’s important to understand what goes into total return. Total return is a component of both price movement as well as interest rate reinvestment. We only had three months of interest rates that were reinvested into our bond mutual funds in the first quarter. We still have nine more months of interest payments that are going to help to offset that price movement that we saw because rates went up.
The other thing to keep in mind is that bonds right now are coming off of extremely low yields in a very low inflationary environment. As the Fed tightens to return to a more neutral monetary policy, you’re going to have headwinds against your bonds. I just remind investors to be patient as we move through this rate tightening cycle.
Joel: So what’s the payoff? If investors are patient through periods like the one in the first quarter of 2018, what’s in it for them at the end?
Steve: Well right now, yields are very, very low, and investors might be frustrated by those low yields. But those that are patient are going to be rewarded with much higher rates at the end of this rate tightening cycle. What’s nice about a bond mutual fund is you have fund managers that get money coming due every single day. And as that money comes due, they’re able to re-up it at the new higher prevailing rates as we go through this period of rising rates.
And, as rates continue to go up, bonds themselves will become more attractive relative to stocks. Right now, the spread between the earnings yield in the stock market and the prevailing interest rates in the bond market is very wide. But as bond yields go up, they become more competitive, and investors are compelled to invest more money into bonds, which does create a tailwind for our bond fund investments. At the same time it could create a headwind for some stocks.
Joel: What about cash? What role does that play right now?
Steve: Cash is important for short-term emergency reserves. And, although it is an important piece of your day-to-day cash flow, I don’t like to think of cash as a component of the bond portion of a well-diversified portfolio.
Joel: What should investors do to keep their patience while interest rates are rising?
Steve: They need to focus on more intermediate-term duration bonds. You want to have a fund that has a big enough shock absorber in their current yield to offset any pullbacks that we might get as rates go up. And I think it’s also important to pay attention to the investment grade quality issues. This late in the business cycle, avoid the urge to invest in the higher yielding, often lower quality bonds that are out there, and instead focus on the investment grade quality intermediate term bonds.
At the end of the day, it all comes down to balance, Joel. Bonds play a critical role in your portfolio and should make up any well diversified plan.
Steve Giles is vice president and investment advisor at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
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(initially posted April 13, 2018)
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