The bond and bond-related exchange traded fund markets have experienced quite a year, but the good times may soon come to an end. The specter of inflation and likely hikes in interest rates may cut away at hefty returns seen in recent months.
A bond is a loan that a bond purchaser makes to a company, as stated in American Chronicle. Thomas E. Murphy, certified financial planner at TEMAA Financial, says bonds serve to reduce volatility in a portfolio while generating income – the quarterly, semi-annual or annual fixed income is generally more than dividend payments from stocks. [iShares launches muni bond funds.]
Bonds have an inverse relationship with market interest rates – the price of a bond falls as interest rates rise. Bond investors may use a strategy called “laddering” to decrease interest rate risk by buying bonds of various maturities. As a bond matures, you may reinvest in higher-yielding bonds if rates rise. [What to watch as yields rise.]
One option for diversifying your bond holdings is by buying ETFs, which give exposure to hundreds or even thousands of bonds in one single transaction. However, it’s important to approach your bond portfolio as you would your equity portfolio and to be prepared to adjust as conditions change.
The decline in inflation, which is practically at zero, and the sharp decline in market interest rates may be indicators of a reversal of fortune for the Treasury bond market, writes Paul J. Lim for CNN Money. Peng Chen, president of the investment consulting firm Ibbotson Associates, believes a bear market in Treasuries may occur if inflation rises and the Fed has to raise interest rates.
Here are three strategies for the fixed-income investor:
- Don’t want to incur loses? There is virtually no credit risk if you stick to U.S. Treasuries since the government won’t default on the loan. But rates may rise and reduce your bonds’ value in the open market. Among your options: Reduce risk by keeping to short-term exposure, which reduces vulnerability to price swings; keep a portion of Treasuries in individual issues and ladder your securities; and/or put some money away into Treasury inflation-protected securities (TIPs).
- More risk-tolerant? Consider taking on sovereign debt of other countries. Foreign debt also has the added benefit of a exchange rates, especially if the U.S. dollar is weakening. An easy way to access international Treasuries is through ETFs. [Diversify with international bonds.]
- Not too risky, but not too safe? Try adding some municipal or corporate bonds into the mix. It should be noted that munis are also free from federal tax and, in some cases, state and local taxes. Corporate bonds also help reduce a portfolio’s potential exposure to losses.
Max Chen contributed to this article.