When I was a teenager, my father took me to an empty parking
lot to practice driving on ice and snow. Skidding is an eerie
feeling. When you first lose control of the car, your gut
reaction is to step on the brakes.
But as I quickly learned, stepping on the brakes only makes it
Steering the car where you want it to go and gently
accelerating is the best way to regain traction on slippery
Maybe that's a strategy the U.S. Federal Reserve should
For roughly three months, the Fed has been talking about
cutting back on its asset-buying program. Currently, it is
purchasing $85 billion in long-term Treasuries and mortgage
backed securities in an effort to keep long-term interest rates
low. But the Fed would like to slowly ease -- or taper -- out of
This has proved, however, to be a slippery proposition.
The Fed has still not curtailed its program, yet long-term
Treasury rates have already started to soar -- even past the
point where the Fed is comfortable.
On August 21, the Federal Reserve released the minutes of its
July 31 meeting. While the members still supported curtailing its
asset buying program, they were divided as to when and how they
should proceed. Mixed economic data had some members "less
confident" about an uptick in the U.S. economy in the second half
of this year. The recent rise in Treasury yields had already
pushed up mortgage rates, and members viewed this as a threat to
the recovery in the housing market.
The Federal Reserve has worked hard to be transparent about
its plans and opinions. But when the central bank is divided,
this transparency serves to magnify the uncertainty in the
market. After all, would you want to be a passenger in a skidding
car while the driver was unable to decide whether to brake or
step on the gas?
Don't Let the Fed Make You Complacent
I have written about interest rate risk many times this year,
starting with my January 2013 issue of
The Daily Paycheck
Fixed-income securities do have interest rate risk. But
securities with short maturities and high yields -- referred to
as "low-duration securities" -- have lower interest rate risk.
The chart below shows how this has played out over the recent and
dramatic rise in rates.
Almost all bonds and bond funds dropped in the weeks following
the Fed's first mention of a policy change. But the
short-maturity, high-yield bonds (as represented by HYS) bounced
back. The longer-maturity high-yield bonds (
) stabilized. At the same time, the long-maturity low-yielding
) continued to tumble.
The increase in interest rates has started to stall. Some
investors feel the worst might be over. Maybe it is. Or maybe it
is just the eye of the storm.
I still believe the environment is risky and uncertain for
fixed income. This is not the time to get complacent. This is a
good time to be vigilant about reducing the interest-rate risk in
your portfolio. (If you are looking for information about the
duration for any of your income holdings, funds typically provide
this calculation on their websites.)
Earlier this year, I sold most interest-rate sensitive
securities in my
portfolio. I still, however, hold a number of fixed-income
securities. Although they may come under some pressure if
interest rates continue to climb, I'm more than happy to continue
to hold them and reinvest dividends back into them.
After all, that's exactly the point behind
The Daily Paycheck
. We want to take advantage of the power of compounding to
supercharge our income portfolios while limiting the amount of
risk we take on over time.
Action to Take -->
I continue to recommend funds like the
PIMCO 0-5 Year High Yield Corporate Bond ETF (
-- which pays a handsome 5% yield and carries very low interest
rate risk -- to new investors. But I would not recommend rushing
into any new fixed-income positions with higher durations until
there is more clarity and stability in the market.
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