New Year's Resolution: Rethink Your Traditional Bond Portfolio

by: Jeffrey Rosenberg

The end of the year is always a good time for reflection, and for thinking about what went well in our lives and what didn't. From an investment perspective, one thing that fits in that latter category are investments in traditional bonds.

But the New Year also brings with it the time to make resolutions and changes. We believe that all investors should consider reviewing their bond portfolio to be sure it remains built to deliver their goals, whether those be income, principal protection or both.

We touched on this in BlackRock's recently released list of five things to know and five things to do in 2014, and with our view that interest rates are likely to rise, we believe the risks embedded within certain parts of the market have increased. Thus, you should rethink how you're invested. Let's discuss the outlook first:

  1. Modestly stronger growth should lead to slightly higher interest rates. But we do not expect a sharp or rapid acceleration. As the Federal Reserve begins to slow its extraordinary bond-buying program, we believe the 10-year Treasury yield will modestly climb around 0.5% by the end of 2014.
  2. Low for Longer. It's important to note that while the bond-buying program will be slowed, to avoid negative economic consequences of a sharp rise in rates, the Fed will likely promise to keep the Fed funds rate low for some time.
  3. Given the continued slow growth nature of the recovery, inflation, now at a four-year low in the United States, is likely to stay low at least through 2014.

The key point in #1 above is made nicely in this graphic below:

What does this mean for bond investors? And what investing resolutions should you make in 2014?

Here are three we would offer:

  1. Traditional bonds could experience losses. For example, if we take a broad category of bond funds held by investors such as the Morningstar Intermediate Bond Category, a 1% rise in interest rates would mean approximately a 5% loss in principal. A 0.5% rise in rates could mean a 2.5% loss of principal, which would offset the income from the coupon payments and lead to overall losses. Longer maturity bonds hold more of this interest rate risk than shorter-maturity bonds, so be mindful of the maturities in your bond portfolio.
  2. Since inflation is near flat, bonds designed to protect against loss of value to inflation might not be worth owning such as Treasury Inflation Protected Securities (OTC:TIPS). Except in the longest maturities, in our view, they are expensive and we would keep them at a minimum in a portfolio.
  3. Bonds that trade based on credit, or the ability of the issuer to pay back its obligations, offer a way to gain income with lower interest rate sensitivity. While not inexpensive, they generally offer higher yields and less sensitivity to interest rate increases. In particular, we favor high yield bonds.

The opinions expressed are those of Jeffrey Rosenberg as of 12/11/13 and are subject to change at any time due to changes in market or economic conditions. The comments should not be construed as a recommendation of any individual holdings or market sectors.

Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies.