(PUB) Investing 2016

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17 Morningstar FundInvestor October 2016
leveraged borrowers if the market believes the rate
hikes will succeed in slowing growth and thus
imperiling those borrowers’ future health,” he said.
On the other hand, if the economy softens—and
economic data aren’t universally strong, which is one
reason the Fed hasn’t yet moved aggressively to
raise rates—the default rate for high-yield bonds
could go up. That’s not to say that you shouldn’t
own high-yield to serve as an aggressive complement
to your high-quality fixed-income portfolio, but
check your existing exposures first; portfolios with
plenty of equity exposure probably don’t need
high-yield exposure. Also plan to have a nice long
time horizon of 10 years or more.
Treasury Inflation-Protected Securities
No one has ever suggested that Treasury Inflation-
Protected Securities would hold up well in times
of rate increases. Holders of TIPS get an adjustment
in their principal values to reflect increases in the
Consumer Price Index, but when CPI is on the move,
interest rates often are, too. In times of economic
strength, TIPS have the potential to give with one
hand (by delivering an inflationary adjustment)
and take away with the other (by falling in price
amid rate changes).
Yet investors might be surprised at just how rate-
sensitive TIPS actually are. The Barclays Aggregate
U.S. Treasury Inflation-Protected Securities Index,
along with most core-type TIPS funds, has a duration
(a measure of interest-rate sensitivity) of eight
years or more, longer than the Barclays Aggregate
Index, which has a duration of about five years
today. Add in the fact that TIPS yields, as is the case
with nearly every other bond type, have slunk lower,
meaning they’ll provide less of a buffer against price
declines than was the case in the past.
As with high-yield bonds, this is not to suggest that
investors should shun TIPS from their portfolios;
in fact, I consider them even more central than junk
bonds, especially for retirees. But it does point to
the virtue of carefully considering your time horizon
when deciding what type of TIPS product to buy.
If you have a shorter time horizon of, say, seven or
fewer years, you may well be better off in a shorter-
term TIPS fund like Vanguard Short-Term Inflation
Protected Securities VTIPX. If your time horizon is
longer, a longer-duration, core-type TIPS fund is fine,
because it’s apt to compensate for its higher vola-
tility with higher returns over a longer holding period.
High-Yielding Stocks
As bond yields have declined, investors have increas-
ingly been using dividend-paying stocks in lieu of
bonds. Many high-quality dividend-payers currently
feature yields that are higher than high-quality
bonds’; indeed, the current yield on the S&P 500
(~2.2%) is higher than that of the Barclays U.S.
Aggregate Bond Index (1.8%). Moreover, stocks have
more leeway for capital appreciation than bonds,
albeit with more downside potential.
In terms of interest-rate sensitivity, a feather in the
cap of dividends is that the amount of dividends a
company pays out is determined by its board;
current market yields may play a role, but corporate
strategy and capital-allocation considerations are
more important. By contrast, the yield a company
must pay on its bonds is largely determined by
the marketplace and prevailing yields at time of issu-
ance. Thus, bonds tend to be more directly affected
by rising rates than dividend-paying stocks. Addition-
ally, because higher interest rates are typically the
product of strong economic environments, stocks
may in fact behave reasonably well amid periods
of rising interest rates; specific industries, such as
banks, may actually benefit.
You can expect to see stocks that investors have been
using mainly for current income in lieu of bonds,
however, struggle in a rising-rate environment. On the
short list: utilities, REITs, and higher-yielding
consumer staples and pharmaceutical names. K
Contact Russel Kinnel at