As bond market sputters, what should investors do?
Bond investors have had a long successful ride. Now, though, with interest rates on the rise, that appears to be coming to an end. But is the bond bull market, which began in 1982, really dead meat? And going forward, how should you invest in bonds?
The long rally was touched off after the Federal Reserve’s chairman at the time, Paul Volcker, started racheting up short-term interest rates in the late 1970s to combat double-digit inflation that had the U.S. economy in a stranglehold. By 1982, Volcker had succeeded in defeating inflation, and bond prices soared -- the benchmark 10-year Treasury note has more than tripled in price since then. Add in interest payments, and investors in those notes scored a bonanza.
Interest rates on bonds move in the opposite direction from bond prices. That’s why investors did so well as the 10-year Treasury, which yielded almost 16 percent at the end of 1981, tumbled all the way down to 1.4 percent in July 2016. Lately, after the Fed’s second quarter-percentage-point increase in a year, the T-note has climbed to 2.5 percent, which translates to a 9 percent price decline.
“More pain is coming,” warned Al Martinez, a managing director at investment firm High Tower Boca Raton in Florida. He predicted that the 10-year Treasury will yield 3 percent in early 2017.
The Fed wants to hike rates three more times in 2017, amid a slight uptick in inflation and to restore rates to their historical level now that the economy seems to be doing better.
For that and other reasons, the 35-year bond bull market is over, according to a number of savants. To Peter Boockvar, the chief market analyst for Lindsey Group, a Washington, D.C., advisory firm, it’s high time “to call the bottom in global interest rates and the top in prices.”
Here’s what investors should consider now:
Why the bond market is important. The fate of the bond market should concern every investor, and not just because a seeming growth vehicle is losing its horsepower. Classically, bonds function as the ballast to a portfolio. During the past 10 years, the S&P 500 (the standard stock benchmark) and the Bloomberg Barclays U.S. Aggregate Bond Index have each climbed about 60 percent, but the bond index’s ascent has been much more smooth.
Because stocks are much more volatile than bonds, investing in the S&P 500 has been a storm-tossed passage. The stock index lost almost half its value during the 2008-09 financial crisis, before recovering and hitting new highs. The traditional investing advice is to keep a 60-40 stock-bond balance, so the steadier fixed-income category can help cushion stock gyrations.
And since buying individual bonds is an expensive proposition for ordinary investors -- thanks to broker commissions and unfavorable spreads between bid and asked prices -- financial advisers tend to recommend using bond mutual funds or exchange-traded funds instead.
Only a hiccup? It can be argued, however, that the current pummeling of bonds is merely a hiccup, and the bull run will continue, perhaps in a more restrained fashion. When that will occur is uncertain. Humberto Garcia, chairman of Leumi Investment Services’ investment committee, wrote in a research report that “the immediate hit to fixed income valuations is likely to hold” until Washington policy questions, like reducing regulations, are resolved.
The last big hiccup, which roiled the bond market mightily, was in 1994. Alan Greenspan, who succeeded Volcker at the Fed, feared that an expanding economy would increase the tempo of inflation. So he set about boosting short-term rates to 5.5 percent from 3 percent, the first tightening of credit in five years.
The bond market plunged: The 10-year Treasury saw yields increase to 7.3 percent from 5.6 percent in three months.
At the same time, the stock market also slid, something that seldom happens during a bond rout. The S&P 500 dropped 7 percent during the same period.
This showed that, in 1994 at least, investors were spooked that more expensive borrowing costs would harm corporate earnings. The effect was temporary, though, as both stock and bond markets recovered and the 1990s boom kept going.
Yet in late 2016, markets are behaving more normally. Stocks have done well, setting new records, while bonds have sagged. What’s more significant, bond bulls think today’s world demands that rates stay, in the phrase popular on Wall Street, “lower for longer.” If that happens, any bond rout will be muted.
It’s encouraging that the present Fed wants to raise rates using “a systematic, methodical approach,” said Matt Lloyd, chief investment strategist at Advisors Asset Management in Monument, Colorado. He noted that rates still are on the low side, historically. “And they won’t skyrocket.”
How to invest. With rates nosing upward, many advisers recommend a barbell strategy, in which you pair shorter-term bond funds (which suffer less when rates rise) with longer-maturity ones that will recover eventually and offer better yields.
Among the latter, “junk bonds” -- those with less-than-stellar credit ratings -- have held up pretty well since Donald Trump’s election. That’s likely because junk tends to track the stock market, and the economy seems sufficiently robust that the risks of default for the bonds is low.
Sarah Bush, director of manager research for fixed-income at Morningstar, noted that junk is the top-performing bond fund category this year, up 13 percent.
While inflation remains muted, it does appear to be on the upswing to a degree. That’s why Collin Martin, director for fixed income at the Schwab Center for Financial Research, has recommended Treasury Inflation Protected Securities, or TIPS, which have a built-in escalation mechanism to keep the bonds’ value abreast of inflation, the bane of fixed-income investments.
In the past, low inflation made them also-rans whose prices dipped as a result. So right now, he contended, “they are priced at an attractive level.”
One sector to be more wary about, Morningstar’s Bush warned, is municipal bonds, which benefit from being tax-free. If Mr. Trump succeeds in lowering federal taxes, she noted, their appeal will sag and their returns will be lackluster.
And of course, you can always turn to so-called “bond-equivalents.” Chief among them are real estate investment trusts (REITs), which generally are pools of property that pay nice dividends drawn from tenants’ rent payments. Since Oct. 1, REITs have fallen 8 percent, but they do have a nice 4 percent yield and are cheap.
As always with investing, it pays to be diversified. And the turn of the year is a good time to rebalance your portfolio in case your asset allocations have gotten out of whack -- as in no longer divvied up to meet the 60-40 paradigm.
Say you have too much in stocks due to their run-up. As Rick Kahler, head of Kahler Financial Group in Rapid City, South Dakota, put it: “The simple case for rebalancing can be made by using an old market axiom: sell high and buy low.”