Should I invest in bonds now or after the presumed interest rate hike?
I am trying to diversify a portion of my portfolio into bonds. However, with the upcoming interest rates raise announced by the Feds before the end of the year, I am not sure that it is wise right now. Could you clarify what kind of bonds are more vulnerable to an interests rates raise (Short-Term, Long-Term, Intermediate-Term, TIPs, etc)? Is it wise for me to keep the portion, initially allocated for bonds, in cash until after the interest rate hike?
If you knew without a drop of uncertainty that Yellen and her cohorts at the FOMC will announce a rate hike at the coming Fed meeting (and the market did not possess such knowledge), it would be wise to wait and invest in bonds after the rate hike. Why? Rising interest rates, no matter how small the coupon or how short the bond's duration, hurt the value of fixed rate bonds - when the prevailing market rate rises, it makes the coupon on fixed rate bonds inherently less valuable. For example, suppose the Fed meeting is tomorrow, and I buy a 5% semi-annual bond at par ($100). Tomorrow the Fed comes out and says they're hiking rates from 25-50bps to 50-75bps, with subtle hints at a more rapid upward interest rate trajectory. The market may very well take these hints as if they were set in stone, causing a sell-off in fixed rate bonds as investors overreact to the news (standard procedure, especially when it comes to the Fed). In this case, the bond I bought yesterday for $100 may decline to $98 in value, in which case I would have been better off buying the debt on the cheap after the Fed's announcement.
What's important to note though is that the Fed, under Chair Yellen, is infamous for acting as though they plan to raise rates but coming up with consistent excuses to do nothing. For almost the entirety of 2014, Chair Yellen had the market believing at each successive meeting the FOMC would hike rates, but it wasn't until the end of 2015 when they finally did something, marked by a measly 25 basis point hike to the Fed Funds Rate. Despite all the empty promises, the market continued to overestimate the likelihood of a rate hike throughout 2014 and 2015, time and time again. As a result, I would be remiss if I didn't mention the likelihood the Fed comes up with another excuse to do nothing, leaving you wishing you would've bought those bonds before the meeting - fixed rate bonds would likely rise in value after a no-action announcement as the market resets its expectations for the interest rate trajectory.
The Fed will continue to tinker with market expectations, but I expect they will keep a tight lid on interest rates accompanied by a loose policy stance over the coming years. During recent testimony after the last Fed meeting, Chair Yellen even suggested the Fed may eventually considering going out and buying up stocks in the open market. Monetary policy doesn't get more accommodative, with the exception of negative interest rates (which FOMC members have also suggested they would consider). Accommodative monetary policy is bad for the value of fixed payments to be received in the future, as it typically results in dollar devaluation, making future dollars inherently less valuable than those held today. This makes sense, logically. If you flood the market with newly printed dollars created from thin air, the supply of dollars in circulation goes up while demand for it stays flat. As a result, this increase on the supply side should lead to a lower overall value, provided other countries aren't also printing equivalent amounts (or more) of their respective currencies.
Considering the composition of the Fed today, it's not going to change its stance - we're likely to see continued accommodation for some time, which should support equity markets but won't help fixed income. If you're looking for a hedge against equity exposure, there are alternatives that work better than fixed income. For instance, the VIX, or the volatility index, which is considered the equity market's "fear guage," has a large, inverse correlation with equities. It went through the roof in 2008/09, and call options on the index (which can be purchased on the CBOE) made their holders rich (or very, very high returns at the time). Investing in options is risky, however, as you face the potential to lose your investment in the option premium, so please make sure you understand what you're investing in before considering investing in options (and I'd recommend longer-dated expires when it comes to VIX).
It depends on what type of bond you are purchasing. Typically, larger term bonds have a longer duration and therefore are more prone to interest rate risk when rates rise. That being said, if you own an individual bond, even though you may have a 10 year bond with a duration of ten, and if rates rates rise by 1% your bond price decreases by 10%, you will still get PAR VALUE at maturity. Not so with a bond mutual fund. This is why I 100% prefer individual bonds that have a defined maturity date over bond mutual funds every day of the week.
The advisors who have never traded individual bonds will say that you are taking on too much risk and you won't know which bonds to pick, etc. Hogwash! You can very easily buy 40-50 bonds, and spread your risk out across multiple sectors, asset classes, and time frames to generate a nice 5%-7% annual return portfolio. Actually, if you do this the right way, you want rates to rise because people who bought the wrong kind of bonds and who don't know what they're doing get all crazy and start jumping off the cliff like scared lemmings. Then sell their bonds and a loss, and if you've staggered your portfolio with money maturing each year, you are picking them up at a substantial discount and value. Brilliant!
So, YES you should invest in bonds, but get the right individual bonds from the right advisor that can help you put these things together. More income + less risk + greater returns. Fantastic.
The determining factor in loss of principal due to rising interest rates is the duration of the bond. The longer the term of the bond, the more vulnerable its selling value will be to rising interest rates. If you are concerned about rising interest rates, you would want to avoid the purchase of a long term bond. A short term bond will be less vulnerable.
A bond mutual fund contains many bonds, and the average duration of the bonds in the fund is published. It is a useful data point, because duration is a good indicator of how vulnerable the bond or the bond fund is to rising interest rates. For every increase of 1% in prevailing rates, the bond fund will lose a percentage equal to the duration. For example, if you purchase a bond fund with a duration of 4%, and prevailing interest rates rise by 2%, the expected drop in price would be 8%.
If a bond fund investment will be retained for many years, it will actually grow more in value if interest rates rise. True, it will drop in value over the short term, but over the long term it will grow faster, because as bonds within the fund mature, they will be replaced by new bonds with higher interest rates.
Also, keep in mind that although the Federal Reserve controls short term interest rates, they have very little to do with the more meaningful longer term rates. So much lending now takes place outside of the banks, that in effect the market leads, and the Fed follows. In other words, we really don't know whether interest rates are going to rise, regardless of what the Fed does.
Summary: go ahead and invest now.
First off, it's unwise to attempt to predict interest rate hikes. The Fed only really controls the inter-bank lending rate, which will impact longer rates. The reality is that the market itself has already seen interest rates creep up over the past year (before the Fed took any action to do so). The market itself ultimately dictates where interest rates go.
In regards to the second part of your question, generally speaking, short-term, high-quality bonds are the least vulnerable to interest rate increases. Long-term, low-quality bonds suffer the worst (high-yield bond funds, aka "junk" bonds, took a 20% hit last time the fed announced their miniscule interest rate hate). For TIPS, the impact depends on why rates are rising. If it's an inflationary rise in interest rate, then TIPS offer protection. However, if its simply an interest rate rise that is not due to actual inflation, the TIPS will not be immune.
Is it wise to keep your bond portion in cash? It depends on why you're investing in bonds. If you're doing it for the diversification factor, then no, you should invest in shorter-term, high-quality bonds. If you're doing it because you need that money in a year or two, then sure, it's probably best to simply keep it in cash.