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Why invest in bonds when interest rates may finally be rising?

By Kevin Burns

“Bonds provide current yield, have maturities where the principle will be returned and are less volatile than many other investment assets classes.”

Long ago, one of my most prescient clients said something I will never forget. She was in her late 80s when she told me, “Only God knows which way interest rates are going to go.” As a rule, bond prices generally rise when interest rates fall and fall when interest rates rise. For the last 30 years, rates have generally decreased and bonds have enjoyed excellent returns. This could be changing.

Recently, outflows from bonds and bond funds have been enormous. Liquidity in many of the fixed income markets has become strained as large financial institutions have committed less of their capital to maintain an orderly market. Interest rates have risen by the largest percentage in over 30 years. This has made bonds quite volatile, and many bond investors have seen their fixed portfolios sustain the largest drops in recent memory. If this is true, why own bonds at all?

Most investors should own bonds as part of a diversified, low-to-moderate- risk portfolio. Bonds provide current yield, have maturities where the principle will be returned and are generally less volatile than many other investment asset classes.

But it is important to note that not all fixed-income investments are created equal. Bonds have different
backing, maturities and taxation lev- els. Trading in bonds can be like the Wild West, given the spreads between buying and selling a bond. Also, not all types of bonds react negatively to rising interest rates. And what if my elderly client is right, and we really don’t know that rates will rise—and they all of a sudden begin to fall?

So how does a smart investor navigate the current fixed-income terrain? Our preference is to opt for a professionally managed bond portfolio with some of these potential solutions:

  • Reduce government bond expo- sure and shorten durations. This way, if rates do rise, you can reinvest at the higher rate.
  • Add intermediate-term municipal bonds. Interestingly, in the last few rising-rate environments, intermediate municipals actually rose in price while the Federal Reserve increased rates. When the Fed acts this way, the yield curve usually flattens, short rates rise and the intermediate sector of the yield curve does well.
  • Invest in reinsurance bonds. These bonds have floating rates based on a sizable spread over short-term rates. If rates rise, so will your coupon.
  • Index some of your bond portfolio to inflation. Short-duration, high- quality municipal bonds matched
  • with a similar duration consumer price index may blunt some of the damage to fixed income during a rising-interest-rate environment. In most cases, as rates rise, so do inflation expectations.
  • Seek out lower-credit quality bonds. When panic sets in, as recently occurred in the bond market, opportunity abounds. It may be appropriate for some investors to consider some of the lower-credit quality bond offerings, especially if they utilize a professional manager with a history of buying improving credits early.
  • Diversify asset classes even further. Consider investing in master limited partnerships (MLPs), which often have an inflation kicker, raising distributions when inflation rises. Look at high-dividend-yielding real estate investment trusts (REITs), which could benefit from higher inflation. If daily liquidity is not necessary, consider alternative investments, like absolute return hedge funds, as part of a broad-based portfolio.

My elderly client was right: It’s hard to anticipate where rates are going. Therefore, it makes sense to stick with a portfolio that diversifies asset classes (including bonds), diversifies management styles and rebalances periodically based on an overall wealth management plan.

November 2013