For much of the past two years, the bond markets have
confounded observers who were forecasting a rise in yields. As
the Federal Reserve gears up for an inevitable interest rate
hike, though, the pressure will likewise be dialed up on fixed
Theres nothing on the traditional bond front
that I dont think stinks, says Matthew Tuttle,
manager of the $42.1 million Tuttle Tactical Management
Multi-Strategy Income ETF at Etfis Capital in New York.
Bonds have been in a bull market for 30 years, and that
cant last forever.
Fed chair Janet Yellen has intimated that the
central bank will hike rates ever so slowly
this year if economic conditions continue to strengthen. The
Feds target for the federal funds rate has stood at a
record low of zero to 0.25 percent since December 2008. The
unemployment rate, one key Fed consideration, fell to a
seven-year low of 5.3 percent in June. It will be nice if
it plays out gradually, says Charles Lieberman, chief
investment officer at Advisors Capital Management, a $1 billion
registered investment adviser in Ridgewood, New Jersey.
But the risk is, it doesnt because of the
progressive tightening of the labor market.
Although some economists believe the Fed will boost rates
just once this year, Michael Cloherty, head of U.S. rates
strategy at RBC Capital Markets in New York, sees two hikes.
According to him, the Treasury market is pricing in a peak
federal funds rate of 2 percent, he says. But the Fed
always overshoots in tightening and easing, he adds.
The market isnt pricing in nearly enough risk for a
bigger hike. Cloherty expects economic growth of 2.75
percent for the second half of the year, compared with an
average rate of 1.5 percent for the first two quarters. That
will help push inflation a bit higher, he says: There
wont be massive inflation, but with the ten-year Treasury
yield not far above 2 percent, you dont need massive
inflation to make that look like a bad investment.
Cloherty sees the ten-year Treasury yield climbing to 2.7
percent at year-end, from 2.26 percent as of August 6, and then
to 3.5 percent by the end of 2016. The market hasnt seen
yields that high since the spring of 2011, but that is still a
low level by historical standards.
The Feds tightening will prove quite unnerving to bond
investors who shifted to the asset class to preserve capital
following the 200809 financial crisis, Lieberman
says. They will discover they can lose money pretty
effectively in bonds also.
The problem is magnified for investors who buy bond funds
rather than the bonds themselves. An investor holding an
investment-grade bond to maturity should receive the
bonds par value. But if bond prices fall for a sustained
period, there is no guarantee a bond fund will rebound to any
set price let alone the cost of purchase. As a
bond fund investor, you may not be protecting your capital, and
fees could be cutting into your income, says Mick Heyman,
executive and sole owner of Heyman Investment Counseling, a $35
million RIA in San Diego.
A bear market in bonds could hit retirees particularly hard,
as many of them have built their portfolio around the asset
class. All the advice we give people near retirement is
to reduce risk based on bonds past performance,
says Tuttle. If that [past performance] doesnt
hold, bad things will happen. And he thinks bad things
will happen. When the bond bubble bursts, it could be
worse than stocks, Tuttle says.
So whats an investor looking for secure income to do?
Some experts recommend dividend stocks, preferred stocks, real
estate investments trusts and master limited partnerships. To
be sure, the income from these investments isnt
guaranteed, and the value of the investments can easily fall.
Someone with a long time horizon and a tolerance for volatility
would do well to consider blue-chip dividend stocks, Heyman
says. That would give investors a yield of more than 3 percent,
in some cases, with the potential for capital appreciation. To
be sure, someone primarily concerned about protecting capital
should consider a laddered portfolio of Treasuries or
high-quality municipal bonds, with a variety of maturities, he
advises. In a rising interest rate environment, the proceeds
from maturing bonds could be invested in paper with higher
yields. And, so long as investors dont buy the bonds
above par, they should avoid losses on principal.
Lieberman hasnt given up completely on bonds either.
The most effective strategy is to shorten
maturities, he says. The shorter the maturity, the
less sensitive a bond portfolio has to rising interest
rates. The average duration of his firms
fixed-income portfolio is only one year, which Lieberman says
is a testament to his firms concern about risk.
Overall, though, the future looks bleak for bonds, many
investors say. Problems like Greeces debt crisis and
Chinas stock plunge can cause a brief flight to
Treasuries. Longer term, I dont see how the math
works, Tuttle says. The Fed has stolen future
returns for bondholders. I would be shocked if my view were to
change in the next year or two.
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