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Given that they’re often considered the safe, boring
part of investors’ portfolios, bonds have certainly
produced more than their fair share of angst during
the past few years. Having enjoyed the tailwind of
declining yields for nearly three decades, many bond
investors have been fretting about the day when
that tailwind would become a headwind.
Those fears were stoked in the summer of
2013
, when
Federal Reserve chairman Ben Bernanke hinted that
the Fed could begin to scale back the bond-buying
program that had suppressed bond yields since the
financial crisis, and consequently provided a glimpse
of what a period of rising rates could mean for bonds.
Not surprisingly, long-term Treasury bonds took it on
the chin, dropping
6%
during the second quarter and
shedding another
6%
in the second half of the year.
Categories such as emerging-markets bond funds
proved quite rate-sensitive, too.
Against this uncertain backdrop, investors have been
mulling—and executing—a variety of strategies to
help protect their portfolios against rising bond yields.
Morningstar’s fund flow data show that they’ve been
shortening up, embracing credit-sensitive bonds, and
eschewing bonds altogether in an effort to defend
their portfolios against rising rates. Yet even as such
strategies might seem eminently sensible given that
bond yields have much more room to move up than
they do down, all of these tacks carry drawbacks
of their own. Here’s a rundown of the key benefits
and pitfalls of some of these strategies.
Shortening Up
The Strategy:
At first blush, the notion of moving
into cash or short-term bonds in lieu of more rate-
sensitive securities looks like the biggest no-brainer
out there. Rising interest rates have the potential to
crunch long- and intermediate-term bonds, whereas
short-term bonds would likely be much less vulner-
able in a period of rising yields. Using a duration
stress test, the typical intermediate-term bond fund
would stand to lose about
3%
of its value if interest
rates jumped up by
1
percentage point over a one-
year period; the typical long-term fund would lose
about
9%
or even
10%
. The average short-term fund,
meanwhile, would lose about
1%
, and cash (
CD
s,
money market funds, and so on) would remain stable.
The Risks:
As investors who shortened up a few years
ago know well, there’s an opportunity cost to hunk-
ering down in ultra-low-yielding cash and short-term
bonds. Even though interest-rate jitters were alive
and well three years ago, the typical intermediate-
term bond fund has gained more than
1
percentage
point more, on an annualized basis, than the average
short-term bond fund since early
2011
. That risk is
arguably more in the rearview mirror than it is a con-
cern on a forward-looking basis. A bigger consider-
ation, however, is how to know when to get back into
intermediate-term bonds once you’ve exited them.
After rates have risen
3
percentage points? Four? More-
over, Morningstar senior fund analyst Eric Jacobson
says that cash and/or short-term bonds, even high-
quality ones, may not provide the same ballast for the
equities in one’s portfolio as intermediate- or longer-
term bonds tend to do. True, short-term bonds won’t
tend to go down much, if at all, in an equity-market
shock, but neither are they likely to gain value during
such a period, either.
Buying Individual Bonds
The Strategy:
Forget bond funds. What about simply
buying and holding individual bonds to maturity?
Whereas the holder of a bond fund could incur prin-
cipal losses if interest rates go up during a given
holding period, the investor in a high-quality bond
would receive his or her principal value back, even
if yields jumped up substantially during that period.
The Risks:
As with shortening up, the investor in indi-
vidual bonds faces potential opportunity costs. By
locking in today’s relatively low rates, the individual-
bond investor who’s buying and holding won’t have
the opportunity to swap into higher-yielding bonds if
Safeguard Your Bond Portfolio
Portfolio Matters
|
Christine Benz
