As interest rates rise, as is now accelerating, bond prices are falling. But that doesn’t mean you should avoid bonds.
You may have read that bonds have performed poorly because the Federal Reserve is tightening monetary policy. That’s only half the battle. Credit quality in the US is good – defaults are rare. Almost all bond issuers pay interest on time.
Keeping part of your portfolio in bonds is actually a way to reduce risk. This may seem unreasonable, but read on. Below are strategies that can help you reduce your bond investment risk, even if the current interest rate cycle is likely to push prices down.
Mechanics of connections
The market value of bonds has fallen. What does this mean for you? If you hold a bond and plan to hold it until maturity, a decrease in market value does not change the fact that you will receive a face value after maturity.
If you buy a bond at a discount (less than face value), you will make a profit when it matures. Conversely, if you paid a premium for your bond. Daily price fluctuations do not affect repayment. You continue to receive interest until the bond matures.
But if you own bond fund shares, the value of your stock goes down. But interest is still flowing, and as the bonds in the fund mature, they will be redeemed at face value and replaced by bonds with higher payouts (or higher yields). This ultimately helps the stock price recover. How worried are you about the decline in the value of your bond fund?
If inflation is at its peak for 40 years, it may take a long time before the direction of raising interest rates (and the corresponding reduction in the market value of bonds) is canceled. Can you wait? How long may you have to wait?
If you have money to invest, a bond fund or individual bond investment has already become more attractive with higher yields.
The case for bonds
The traditional model of exposure in the stock and bond market is called 60/40, with 40% of the portfolio invested in the bond market through individual holdings or shares of bond funds.
The notion of a 60/40 portfolio seemed obsolete during a long period of declining interest rates, when stocks gave some of the best performance in decades.
Central bank stimulus, low interest rates and very low (or even negative) long-term bond yields have pushed money into U.S. stocks. SPX index S&P 500,
the average annual return (with dividend reinvestment) for the last five years is 15.8%. This is compared to an average of only 7.3% over the previous 10-year period, according to FactSet.
Meanwhile, the profits of American companies reached their post-war maximum in 2021:
High inflation and rising costs, especially for labor, and ultimately resistance to rising prices could push the above chart in a different direction. Meanwhile, the Federal Reserve points to accelerating the cycle of raising short-term interest rates and reducing its bonds, with the result that the bond market is already sending long-term rates much higher this year.
Taken together, this makes it an ideal time to consider expanding the bond market, says Mark Halbert.
Find out the expiration date of your bond fund
The average duration of the bond portfolio is an indicator of its sensitivity to interest rates. It takes into account premiums or discounts when buying bonds and is expressed in years. The higher the duration, the more volatile the bond fund will be as interest rates rise or fall, and the longer it will take for the reverse price cycle to decline when bonds mature at face value and are replaced by higher-yield bonds.
Halbert explains how duration affects volatility, and gives simple tips on how to reduce bond fund risk in this aptly titled article in the How to Invest series:
You can overcome your fear of losing money with bonds when interest rates rise – if you understand this one.
The name of the bond fund will give you some idea of its duration – the name of the fund can be “intermediate” or “short-term”. But you need to know the exact duration of your fund, which is easy to do on the fund manager’s website. Average time for Vanguard Intermediate Termeary ETF VGIT,
for example, is 5.4 years.
Since most bond funds manage to maintain a medium duration, Halbert cited a study that shows that a good rule of thumb is that if you keep a bond fund in a rising rate and your stock price falls, replacing maturing bonds with higher bond payouts will offset this decrease if you keep your investment for at least one year less than twice the average duration of the fund.
So for VGIT Vanguard it will mean the opportunity to stay in it for almost another 10 years. Could you do this without experiencing a worse period of falling prices? If so, a bond fund of similar duration remains a viable way to diversify its equity portfolio.
The case of bond ownership to maturity
If you buy your own bonds and keep them until maturity, you know how much you will get back after the maturity of the bonds. You may find it easier to navigate a period of declining bond prices than if you were witnessing a decline in the value of bond fund stocks.
Ken Roberts, a registered investment advisor to Four Star Wealth Management, based in Truckee, California, helps clients looking for income with strategies in the bond and stock markets. During the interview, he discussed various income strategies.
First, here is a list of earnings at the end of the day on April 6 on US Treasury securities with different maturities:
Click on the maturities in the left column to go directly to the categories page of this security.
Click here for Tommy Kilgore’s detailed guide to the rich information available for free on the MarketWatch quotes page.
The yield curve of US Treasury securities is shown above. Interest paid on treasury bills, bonds and bonds is exempt from state and local taxes. Depending on your tax situation, you may prefer to invest in municipal bonds that are exempt from federal income taxes.
The Treasury table gives a good idea of the overall bond market curve, and you can see that three-year and five-year notes have higher yields than 10-year notes. This was an indicator of previous recessions, however it could take a very long time.
Roberts identified three typical strategies for bond portfolios:
Bullets. This strategy means loading intermediate bonds. Treasury Notes US Treasury TMUBMUSD03Y,
have a higher yield than 10-year TMUBMUSD10Y treasury bonds,
and even 30-year TMUBMUSD30Y bonds,
- Barbells. This means the distribution on the short and long sides of the yield curve. The advantage on the short side is fast maturities, which can be replaced by higher-yield securities as rates rise. According to Roberts, this strategy is “probably not the best” for the current environment because of the inverted yield curve. “Bullets make more sense,” he said.
- Stairs. This is a strategy followed by many bond funds. “Probably it works best when the yield curve is normal,” Roberts said. A normal yield curve is one in which longer maturities give a gradually higher yield. He gave the following example: if you have $ 200,000 to invest in a bond and you want to make a 20-year ladder, you can’t allocate $ 10,000 to a bond that matures in a year and so on, up to 20 years. “Then you have one ripening every year. So when the stakes go up, you go ahead and fix the bets. When rates fall, you fix profits. This is a good strategy for working with different interest rates, ”Roberts said.
These strategies may seem complicated, but they are typical ones that you can follow with the help of an investment advisor broker.
Other treasury bond strategies
TIPS denotes Treasury-protected securities that pay interest twice a year, and the principal amount of debt is adjusted upward, based on inflation, or declining if there is deflation. The interest rate is applied to the adjusted principal, so these securities provide good protection for investors in high inflation.
Roberts noted that investors can more easily participate in TIPS with an exchange-traded fund such as the iShares TIPS Bond ETF TIP,
The ETF pays monthly dividends.
A more sophisticated strategy for the TIP ETF is to use covered call options to increase income. You can read more about the strategies for profiting from indoor calls here.
Series I savings bonds are available directly at the Treasury. Setting up a Treasury Direct account online is easy. Savings bonds may seem like a weird concept until you realize that the yield of I-Bonds is now 7.12% if you purchase them by the end of April. The rate is adjusted every six months, in May and November, based on US inflation. Interest is added to the bonds and paid upon their redemption.
I-bonds must be kept for at least a year. They can be redeemed in five years without penalties. If you redeem earlier, the penalty is three months interest. Given that this is the money you want to invest in the long run outside the stock market, this penalty is not very high, especially when inflation and interest rates on bonds I are so high.
Treasury direct accounts are created as individual or corporate accounts. The regular limit on annual I-Bonds purchases is $ 10,000. However, you can also get I-Bonds instead of a federal tax refund of up to $ 5,000 a year. For a pair, two individual accounts make up the usual annual limit of $ 20,000.
Halbert further understands I-Bonds and their tax implications.
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