Are bonds a wise addition to your retirement planning strategy? Learn the ins and outs in this blog series.
This post is the second in a series of posts assessing how American retirement investors should think about risks in the bond market, particularly in light of recent news. You can click here for the first post.
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How much interest rate risk are you exposed to?
With the Fed hiking interest rates on December 16 for the first time in nearly a decade, many fret rising rates will crush bond prices. Given the coverage, many of those creating a retirement planning strategy are wondering whether bonds have a place in their portfolios in the here and now. After all, bond prices and yields sit on opposite sides of a seesaw. If yields rise, prices will fall.
Exhibit 1: The Bond Price Seesaw
The Fed Rate Hike Cycle
While this is true, in our view, many make too much of the risk presented to bond owners by a Fed rate hike cycle, based largely on not familiarizing themselves with the actual history. You just can’t presume the Fed increasing very short-term rates will boost long rates to the same degree—or at all. As we noted on our sister blog, MarketMinder.com, the Fed increased interest rates by 4.25 percentage points between June 2004 and June 2006. But longer-term interest rates rose only half a percentage point. The relationship isn’t 1:1.
What’s more, bond investors actually earn a total return—price movement and yield. Rate hikes most directly ding government bond prices. But yields, if sufficiently robust, can offset. The type of bond matters here, too. Generally, corporate bonds can hold up better during a tightening cycle, as investors may bid prices up and down based on factors specific to the issuer or industry.In an economic expansion (rate hikes usually come during expansions), corporate issuers may see sales and profits rise, making them essentially less risky borrowers. Hence, their yields rise less than comparable maturity Treasurys, a phenomenon called credit spread compression. This is exactly what happened during 1994 – 1995’s tightening cycle, when corporate bonds held up better than Treasurys.
An additional consideration is the duration of the bond. Duration is a measure of how long it would take the bond to pay out the amount of its original principal and a key metric of interest rate sensitivity. The primary inputs are the bond’s interest rate (coupon) and maturity (the length of time until your principal is returned)—the higher the duration, the more sensitive to rate fluctuations your assets are. So, if you have two bonds with identical issuers and maturities, but one has a higher interest rate, that one would have a lower duration (you’d recoup more of your money sooner).
If your financial professional expects interest rates to rise, he or she may want to reduce the duration of your bond portfolio, as this would theoretically mitigate the risk presented by rising yields. They may also wish to consider non-Treasury bonds on the expectation a bull market and expansion will bring credit spread compression.
One must also consider how markets operate. Typically, liquid markets will discount widely expected moves in advance and, if you haven’t noticed, the Fed gets a wee bit of press coverage lately. So it is possible that some influence of a tightening cycle is already reflected by current bond prices and yields.
Driving Return with Bonds
Ultimately, though, we believe a common mistake retirement investors make with bonds is using them to drive return. We believe, the primary benefit bonds bring is reduced volatility versus stocks. Not everyone needs this feature, but if you have sufficiently high cash flow needs, it can make sense to cushion the swings inherent in the stock market.
For this reason, if bonds are appropriate for your situation, you must have an ironclad reason to exit them. A tightening cycle doesn’t necessarily qualify. But it is a reminder that bonds do not equal safety. Educating yourself about retirement planning, what you own, and why you own it is a crucial step in investing. And, if you’d like a second opinion on your portfolio, feel free to contact us by clicking here.
Questions to ask your retirement planning professional:
- What is the average duration of the bonds I own?
- Do you expect rising, falling or flat rates? What is this based on?
- How have you positioned my assets (bond type, duration, maturity) given that expectation?
- Were you in the industry during the last Fed tightening cycle (2004 – 2006)?
- What is your understanding of how long-term rates moved then?