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?

Investing, Bonds / Fixed Income
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October 2016
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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).

October 2016
October 2016
October 2016