How to Properly Build a Bond Portfolio While Rates Are Rising
News flash, interest rates are going up. Nobody should be surprised.
The financial media is on high alert regarding rapidly rising rates and signs of inflation amidst record amounts of stimulus. If you own a bond fund, you might be petrified by the circumstances and would be for a good reason.
All else equal, the net asset value of a bond fund will fall when interest rates rise, and that means if you own a bond fund, the value of your investment is at risk.
With the pandemic still lurking, the Fed continues to pursue very easy monetary policy, and Congress seems wedded to massive ongoing fiscal stimulus packages.
It matters little that such stimulus comes in the form of additional weight to the national debt. Today's political solution is all about going big, and there will be no equivocation. The yield curve has started to respond by steepening and quickly.
Bond market participants have become concerned about future inflationary pressures given the easy money climate. Those worried will demand a higher interest rate to commit to bond investments, which appears to be happening. As interest rates rise, the market price of outstanding bonds will fall.
Thus far, in 2021, the 20-year Treasury Bond yield has increased by approximately 50 basis points from 1.50% to 2.00%, according to MarketWatch data. Over the same period, the value of bond funds has declined. For example, as of February 23, 2021, the iShares 20+ Year Treasury Bond ETF is down over 9% year-to-date, according to Yahoo Finance.
So, what is an investor to do in a period of rising interest rates?
Our advice is to get out of bond funds!
Bond funds are pooled vehicles of investor capital invested in a portfolio of bonds. Naturally, bond fund decisions are driven by the portfolio managers' performance goals. To reach their performance goals, they often invest in higher-risk securities than you, as an individual, would be comfortable investing your 'safe money' in. Fund manager decisions are also influenced by the 'crowd' decisions of other investors within the fund. You, as an individual, are investing for your purposes. Naturally, a bond fund's goals differ from and are sometimes at odds with individual investors' goals like yours.
Good news: you can and should avoid the risks of bond funds.
Let's say you have $1 Million you want to be kept safe and out of the stock market. Part of the reason you want it safe is you have some expenses coming up and want to make sure the money is available when you need it.
Had you earmarked that money for bond mutual funds and invested it early this year, you'd already be sitting on losses. Likely you'd be questioning the safety of your decision. You'd also now recognize that if rates keep rising, you will continue to sustain unrealized losses as the fund's price falls further.
When it comes time to withdraw money for the expenses you planned to fund, if the fund's value has decreased due to rising rates or for other reasons, you'll be cashing in the fund at prices below where you bought it. You'd be recognizing losses on this safe money.
If rising rates cause investors to panic and start massive sales of the fund, the fund's price will likely be under even more pressure. Is there a better way? You bet your bottom dollar there is.
Instead of buying a bond fund, you could allocate your $1 Million to individual investment-grade bonds. In doing so, you would structure the maturities of the bonds you buy to both fund your upcoming expenses and reflect your desire to protect the value of the remaining money, even in a period of rising rates.
As for the expenses you need to fund, you'd buy bonds whose maturities align with the dates you need the money. In the interim, while you own the bond, you would see the market value of those bonds fall if rates rise. However, you don't need the money. You can hold the bonds to maturity.
At the maturity of each bond, you will have received exactly the return you expected when you bought the bond. You get the interest promised and the return of the principal value of the bond. You experience no loss relative to what you expected, and you'd have exactly what you need for expenses when it's needed.
As for the remaining amount you want to keep safe, individual bonds continue to be your best choice. You can buy bonds in a manner that reflects your concern about rising rates. If you think the current increases in interest rates will continue, you will buy shorter maturity bonds. That way, you'll get your money back quicker as the bonds mature. If you were correct, you could reinvest the maturing bonds and capture higher interest rates. If you were incorrect and rates stay low, you lose nothing.
The advantage to owning individual bonds is you are not forced to take losses; you can structure your bond portfolio to meet your needs and expectations. At current low interest rates, we see tremendous advantages to using individual bonds and, quite frankly, see no good reason to own bond mutual funds.
If you would like to learn more about how we structure customized bond portfolios for our clients, please give me a call at your convenience. I look forward to hearing from you.