Why You Shouldn't Dump Your Bonds Just Yet

With stock markets setting new records in 2017, it might be prudent to recall the much weaker start to 2016. In January 2016, the S&P 500 declined 5%, followed by another 5% decline in early February. About a year ago, on February 12, 2016, a rebound started, and the market rallied some 27% since then.

The January 2016 decline was prompted by the first interest rate hike by the U.S. Fed in more than nine years: The Fed raised its main interest rate from a range of 0% to 0.25% to a range of 0.25% to 0.50% in December 2015. Investors panicked despite the fact that both the interest rate increase and its amount were highly anticipated, and, ironically, more money started to flow into longer-dated Treasuries. The interest rate on the benchmark 10-year T-note declined to 1.63% from 2.24% and prices went up. Especially painful was the impact of the rate hike on closed-end funds (CEFs); many of the CEFs I've recommended to my premium The Daily Paycheck subscribers set their 52-week lows a year ago.

However, this year's situation couldn't be more different, despite another December hike.

The Fed waited a whole year, from December 2015 to December 2016, to execute its next rate increase, hiking the main rate by 0.25 percentage points, to a new range of 0.50% to 0.75%.

Market participants largely shrugged off this second hike. The S&P 500 is up 4% year-to-date, interest-rate sensitive utilities are up more than 2% (measured by the Dow Jones Utility Average), the yield for the benchmark 10-year Treasury is essentially flat, and closed-end funds continue to see the average discount contract.

Average CEF Discount

The difference in market action can be explained by the fact that today's outlook for economic growth is much better than it was a year ago. Generally, if interest rates are moving higher because of improving economic conditions, risky assets -- such as stocks -- benefit because credit risk is declining. Moreover, the Fed's rate hike primarily affects short-term rates, rather than impacting rates across the board.

Why You Shouldn't Dump Your Bonds

In a nutshell, bond yields are driven largely by growth and inflation expectations, and both are moving higher. The demand for income plays a role, too. Therefore, the prospect of steeper rate hikes this year, along with rising inflation expectations as well as prospects of fiscal stimulus and tax reform under the new administration will likely keep bond yields moving higher in the foreseeable future.

This is great news for stock investors because these very factors create a favorable environment for equities.

But does it mean that now is the time to dump bonds?

Not quite. While I fully expect the Fed to continue hiking interest rates this year, I also think that bonds will have a place in many investors' portfolios.

This might raise a few eyebrows. After all, if interest rates do climb, bonds will decline -- an inverse relationship between interest rates and bond prices is one of the chief axioms of finance.

However, let's face it: Not all income investors have enough of a time horizon and/or risk tolerance to move 100% of their assets into stocks. Regardless of a positive outlook for equities, we have to remember that stocks are risky assets and can decline at the worst possible moment.

Second, fixed income offers at least some protection in case the markets get too complacent. And finally, high-income stocks can also be vulnerable to interest rate increases. Therefore, fixed income -- bonds -- will surely remain an important part of many income portfolios.

It's simply not plausible to exit bonds altogether. The real question, therefore, is which fixed-income sectors are more attractive in this environment, in terms of both the expected yield and risk.

Indeed, a few fixed-income sectors can be appropriate even in an environment of higher growth and higher rates.

The Assets You Should Be Buying Right Now

The first is corporate debt. Their higher yields make them naturally resistant to interest rate shifts. Junk bonds are also likely to do well in such an environment. These are low-quality securities, leveraged to the health of the economy, sometimes more sensitive to that than the level and direction of interest rates. Junk-bond funds, such as SPDR Bloomberg Barclays High Yield Bond ETF (NYSE: JNK ), typically have shorter maturities, too. For JNK, for instance, the average maturity of its holdings is 6.5 years.

Bank loans and floating-rate securities could also be a good sector to benefit from the potential interest rate increases. Bank loans, like all fixed income, are interest-rate sensitive, and also have credit risk -- but they are shorter in maturity and "junkier" in quality than your average bond. It's not a bad sector to be moderately exposed to in the event of a rate hike, as they can also respond positively to such a hike because coupons on these loans typically reset as rates rise.

Another income sector that looks appropriate for 2017 is preferred equity. Even though this asset class is negatively leveraged to higher rates, this relationship is less straightforward for preferred stocks than for bonds. In addition, the better the credit outlook for the issuer, the more of a positive impact on the total return could be expected.

Altogether, for the year ahead it's better to stick with shorter-duration issues.

And here's another important point. Given that fixed-income investments seem relatively unlikely to outperform equities, now might be the time to lighten up on the sector (without fully exiting it). Savvy investors can use this environment as an opportunity to sell some of the less-promising positions and to take some gains as well.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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