Credit: Shutterstock photoThe nature of investing is one that we are constantly looking in the rear-view mirror to anticipate what our expectations are for the future. This often leads to considerable hopes that existing trends will extend indefinitely or that we will be able to easily spot any rough spots on the road ahead.
Bond investors have likely felt a sense of building confidence over the years as low volatility and global risk aversion have buoyed fixed-income prices. The relative consistency of capital growth, coupled with the “lower for longer” outlook of interest rates, has created a complacent atmosphere overall.
However, the unintended consequence of steadily rising bond prices is the depression of interest rates to historic lows. This in turn deteriorates future return expectations to some of their lowest levels in decades.
The latest data from Research Affiliates 10-Year return calculations puts core U.S. bond indexes at a real expected return of just 0.20%. This essentially means highly diversified funds such as the Vanguard Total Bond Market ETF (BND) and iShares Core U.S. Bond Market ETF (AGG) will experience very little growth over the next decade.
Those same expectations can be extrapolated to individual sectors of the bond market as well. Investment grade corporate bonds, municipal bonds, and even mortgage bonds are typically sensitive to changes in interest rates.
Additionally, long-term Treasury bond funds like the iShares 20+ Year Treasury Bond ETF (TLT) are expected to experience heightened volatility and net losses overall. If the previous five years is any indication of interest rate volatility, then certainly this type of ultra-sensitive fund is in for a wild ride.
The specter of sideways or rising interest rates is a challenge that many fixed-income investors haven’t had to deal with during their tenure in the markets. Bonds have always been a reliable moderator of risk and have experienced very few negative years over the last several decades.
The most recent bout of anxiety was experienced during the taper tantrum of 2013, when the 10-Year Treasury Note Yield rose from 1.6% to 3% in a period of nine months. In hindsight, that event was relatively short-lived, orderly in its path, and setup an excellent buying opportunity.
We have already started to see a notable uptick in interest rates from the 2016 lows as well. It’s far too early to tell if this is the start of a new trend or just a blip on the radar. However, there are some strategic ways to consider adjusting your portfolio or mindset accordingly.
- Keep a rational perspective - Remember that data-driven assumptions are just that – assumptions. They are not guaranteed to come to fruition and are based on varying historical regressions that can change over time. The actual results may be better, worse, or even spot on from where we stand today. If you do decide to make a change to your portfolio, make sure it’s carefully planned and executed with these perceptions in mind.
- Set your expectations low. Bonds don’t trade in a vacuum and are susceptible to changing dynamics that may play out over several years or even decades. Even if you don’t make any changes to your portfolio, you are likely better off if you moderate your long-term return expectations for this asset class. That way you won’t be disappointed if fixed-income doesn’t make much headway in the intermediate-term. Ultimately, bonds can still provide a solid stream of income and may play an important role in reducing the volatility of other assets with a historical penchant for higher risk.
- Enhancing your diversification – One way to mitigate interest rate risk in your core or high-quality bond funds is to consider other avenues of diversification. This means placing a portion of that money in other sectors or asset classes with varying risk characteristics. If your expectation is for continued growth in the economy, then stocks or credit sensitive bonds may be appealing. Some investors may find alternative investments or active management to be an attractive option versus a passive bond index as well.
The bottom line is that investors can make subtle adjustments to their fixed-income exposure to reduce their interest rate risk without abandoning the asset class altogether. Furthermore, preparing in advance for below-average returns can help broaden your outlook to other investment opportunities or simply adapt to a new environment.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
