Should I keep bonds in my portfolio if interest rates rise?
It is easy to get caught up in the daily media coverage about rising interest rates and bond returns and forget why you own bonds to begin with. Fixed income serves two equally important roles in a portfolio: 1) to provide return, and 2) to manage portfolio risk. With rates as low as they are, the expectations for short term future total-returns from fixed income are quite low. However, this is not a good reason to shift assets away from bonds and into riskier assets because it ignores the risk management and diversification benefits of bonds.
A portfolio holding a mix of high quality and diversified bonds plays a critical role in managing portfolio risk, regardless of the prospects of future returns. Predictions of interest rate movements are no better than stock market predictions. Investor's should implement a consistent, diversified, long-term allocation that can weather different types of interest rate environments and conforms to your ability and willingness to take on investment risk. If interest rates rise quickly, the value of a high quality bond portfolio will decline. However, monies are continually reinvested at the new, higher rates as coupons are paid and short-dated bonds mature. As a result of this, history has had very few multi-year holding periods of high quality bonds with negative total returns. Even during a historical period of skyrocketing rates, high quality bonds have still been far less risky than stocks.
The allocation of your portfolio will depend on your investment time horizon, financial goals, ability to take on risk, and willingness to take on risk. There is no one size fits all portfolio allocation. However, all but the most aggressively allocated portfolios have a place for a bond allocation.
First of all, the amount of fixed income anyone should hold depends on four things: (1) their annual lifestyle expenses, (2) the overall size of their liquid investments relative to their lifestyle, (3) the number of years before retirement, and (4) the amount they can save in each year between now and retirement (that is, how big the nest egg will be on day one of retirement). If you expect your liquid investments to be 20 times (or more) your net lifestyle needs (i.e., after Social Security and any pension or real-estate income), you don't really need any bonds at all. Most people keep at least a little, maybe a year or two worth of spending, just to prevent having to sell stocks at the wrong time. If a year or two worth of spending is more than 10% of your liquid net worth, hold a larger portion of bonds.
You will be doing extremely well if you get more than a zero REAL return (i.e, after inflation and taxes) from bonds, regardless of how skilled you or your investment advisor is. Keep that in mind. At the same time, you should expect only modest price volatility to a bond portfolio. So if you are the kind of person who gets fearful when markets go down, then by all means own some bonds and know that with the zero return, you are buying more ability to sleep.
Why would a company issue a bond? Because they thought they could earn more with the money than they would have to pay investors who bought their bonds. Have faith in companies like that. Buy their stock, especially if markets are down and looking scary.
Just like other asset classes, fixed income is important to the majority of portfolios, in most cases as a vehicle to insulate you from equity market risk, which historically provides a higher expected rate of return, but is subject to a lot more volatility. Bond mutual funds or ETFs that have durations longer than 5 or 10 years are likely to fluctuate more during rising interest rate environments. The same holds true with those that have credit ratings below investment grade.
How much exposure really has to do with risk tolerance and time horizon. To generalize, assuming you are a long term investor and have a well-diversified portfolio, conservative investors would be closer to 20% equity 80% bonds, moderate in the 40-60% equity range, and aggressive investors closer to 80% or 100% equity.
A rising interest rate environment doesn’t necessarily mean stocks will be impacted in a negative way because it can be interpreted as a sign that the economy is in better shape than it used to be.
I would agree with Mr. Baker that bonds have a place in most portfolios, even with the risk of rising interest rates. You have touched on the reason why with your last question, bonds reduce your portfolio risk over time. High quality bonds generally do best when the economy is in recession, while stocks generally do best when the economy is expanding. Since we never know when the next recession will hit, it's wise to have some of your portfolio in bonds at all times.
Mr. Baker gives some good rules of thumb for allocations based on your risk tolerance. There are some ways to reduce the risk of rising interest rates in your bond portfolio. They include using ETFs or mutual funds that invest in short duration bonds, floating rate bonds, or have fixed maturities such as Guggenheim's Bulletshares. There are even ETFs that attempt to hedge out the interest rate risk, although they are untested in a rising rate environment. Rising interest rates don't necessarily have to negatively effect stocks, at least not initially. However, after a while, they do. Highly respected economist David Rosenberg has been saying lately that the Fed has tightened 13 times since World War II. In 10 of these instances, a recession has resulted. In recessions, stocks go down.
What I've found to be the best solution is to have different duration of bonds as part of your overall asset allocation because the impact of rising rates will affect longer duration bonds greater than shorter duration. Your specific allocation would need to be determined based on your overall asset allocation and risk tolerance.
Very Truly Yours,
John A. Eiduk, CPA, CFP™