Confused About Bonds? Here’s What To Do

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By Walter Updegrave, RealDealRetirement @RealDealRetire

Ask Real Deal Retirement

I know bonds will take a hit when interest rates rise, but don’t know what to do about that—go to short maturities, intermediate, get out of bonds? I’m confused. What do you think?

      —Dave C.

The first thing you need to understand about bonds is that nobody knows for certain what bonds will do. Yes, I know that everyone “knows” that interest rates will rise from their current depressed levels and that bonds will lose value when they do. Some people also seem to be convinced that when the Federal Reserve acts to nudge rates upward, short-term yields will climb more than long-term, which could mean that short-term bonds will get hit harder than ones with longer maturities, which is the opposite of what usually happens when rates rise.

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I have two things to say about such certitude. First, pundits and various other bond gurus have been predicting that rising rates would inevitably wreak Armageddon in the bond market for some five years now and it hasn’t happened. The broad bond market has sagged occasionally—it lost 4.5% over the course of four months in 2013—but it recovered nicely and has largely defied doomsayers’ prognostications, returning an annualized 4.4% the past five years.

As for trying to predict how bonds of different maturities might perform relative to one another when rates eventually rise, I think a paper titled “Reducing Bonds? Proceed With Caution” that Vanguard published in 2013 and that’s just as relevant today sums it up nicely: “Interest rate movements tend to follow a ‘random walk’ and to be driven by ‘new’ economic events, thus making interest rate predictions little more than guesswork. Or to put it another way: Trying to outguess or time the bond market makes about as much sense as trying to outsmart the stock market—none.

So what, as a practical matter, should you and others concerned about bonds do?

For starters, you should step back a moment and think about why bonds should be part of a long-term investing strategy in the first place. Basically, they provide two things: income and ballast. There’s no doubt they’re falling short on the income front these days what with two-year, five-year and 10-year Treasuries recently yielding a bit over 0.5%, 1.3% and 1.9% respectively with investment-grade corporates paying a bit more. But there’s not much you can do about that. You can stretch for more yield by moving into longer-term or lower-quality bonds, but you’ll be taking more risk too. One way or another you have to adjust your expectations to the realities of today’s market.

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As for insulating your portfolio from market setbacks, bonds at today’s lower yields may not provide quite as much protection as they have historically, but they should still do a good job of stabilizing your portfolio when stock prices head south. For all the hysteria about bonds’ taking a hit when rates start to climb (whenever that may be), it’s important to remember that bonds have never come close to the 50%-or-more declines the stock market has weathered. In the U.S. investment-grade bond world, a loss of even 10% over 12 months would be rare. And while bonds and bond funds will take a hit when interest rates rise, investors who own a diversified fund of high-quality bonds will later see their returns rise as the fund re-invests interest payments in new bonds paying higher rates.

Given all this, I suggest that anyone investing for retirement and other long-term goals start with a broadly diversified portfolio of short- to intermediate-term investment-grade bonds. A total U.S. bond market index fund or ETF —which owns a mix of Treasury, government agency, mortgage-backed and high-quality corporate bonds—would do very nicely as a core holding.

If you feel you need a bit more protection against rising rates, you can put a portion of your bond stash into a short-term investment-grade bond fund. Again, I’d go with a short-term bond index fund or ETF. The more worried you are, the more you can invest in the short-term fund, although be aware that the more you favor short-term bonds, the more return you’ll likely be giving up over the long run. (For guidance about how much of your portfolio you should invest in stocks vs. bonds, I recommend you complete a risk tolerance questionnaire.)

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You can get a sense of how a bond fund will fare when interest rates rise by looking at its effective duration, a figure you can find by plugging the fund’s name or ticker symbol into Morningstar.com and then clicking on the Portfolio tab. Today, the duration for a total U.S. bond market index fund is between five and six years, which means if interest rates rise one percentage point the fund’s price would fall roughly 5% to 6%. Your actual loss would be a bit smaller than that as you would also have the interest payments the bond throws off (which, granted, right now are pretty minimal, say 2% or so).

I think most investors would be fine stopping there, but you can diversify more broadly if you wish—a TIPS or Treasury Inflation-protected Securities bond fund (not a bad idea for retirees), an international bond fund and, if you’re investing in taxable accounts, a high-quality municipal bond fund. But you want to be careful about going much further. For example, domestic high-yield (i.e. junk) bond funds and emerging market bond funds offer the prospect of higher yields, but they can get hit harder too. What’s more, they don’t provide the same diversification benefits as investment-grade bonds as they don’t generally hold up as well  when the stock market is getting battered.

Finally, while some pundits these days suggest substituting dividend-paying stocks for bonds as a way to boost income, I say that’s a big mistake as, dividends or no, stocks are much, much more volatile than bonds. If you want to buy dividend stocks, fine. But they should be considered part of your stock allocation, not your bond holdings.

Or you can ignore the approach I’ve just outlined and try to outguess the bond market, moving to cash and then back into bonds later on or hopping around the yield curve hoping to maximize your return. In which case I hope you’re better at predicting the future than market soothsayers have been the past five years.  (4/27/15)

Walter Updegrave is the editor of RealDealRetirement.comIf you have a question on retirement or investing that you would like Walter to answer online, send it to him at walter@realdealretirement.com.

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