We’ve seen markets get spooked recently as 10-year Treasury yields have continued to climb. On our recent Lifetime Income program, Jim Puplava delves into bond risk and what it means for your portfolio.
Bond Market Risk Ahead
We’re in the middle of a Federal Reserve rate raising cycle right now, and this may be setting the stage for bond market losses for many investors.
To start, the Fed has signaled that it intends to raise rates three times this year, and possibly into next year as well.
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“That would take the Fed Funds rate from 1.5 to about 2.25%,” Puplava said. “Short-term rates are rising, but we’re also seeing medium-term rates break out. The 10-year Treasury note is now at 2.75%, with the possibility that we could see 10-year notes get up to 3 percent this year.”
When interest rates rise, the value of existing bonds decline. Bond values have been increasing since we saw record low-interest rates in the summer of 2017, Puplava stated, and rising rates mean falling bond prices.
Multiple Drivers at Play
But interest rate increases aren’t the only catalyst for bond risk. There are a number of drivers here, including anticipation of the pickup in economic activity, rising wages, rising oil and commodity prices, and overall fears of inflation.
It appears the era of easy monetary policy is coming to an end, here, in Canada and England, Puplava stated, and possibly next year as the Bank of Japan and the ECB are expected to begin raising interest rates.
The Fed is shrinking its balance sheet, as well, which is withdrawing $30 billion a month in liquidity out of the bond market.
Deficits are increasing, and a lot of that is on automatic pilot due to increases in entitlements, Puplava said. All of these factors play into anticipated increases in bond risk.
“There are a number of factors that are all converging that are probably going to drive inflation and interest rates higher down the road,” Puplava said. “The important thing is … if you are in a bond fund, chances are, the bonds in the fund are long-term bonds, meaning that they’re impacted by an increase in interest rates.”
Bond ETFs Present Risk
Many investors in bond ETFs may face bond risk as interest rates increase.
“You can actually see principle losses that are greater than what you’re receiving in income,” Puplava said.
It’s important to remember that as interest rates rise, prices fall on bond funds, negating the returns that you’ve earned from interest. If bond yields spike higher, you can lose more in principle than what you’d make back in interest, as has already happened to many bond investors in the first month of this year.
In the past, we’ve seen a brief period with rises in rates. We had them in 2011 and again in 2013, after which they came down quickly, Puplava noted. Since 2009, most have been earning interest on bond funds with principle left intact because interest rates were declining.
Now, however, things are different. We’re starting from a historically low level of interest rates, so strategies for wealth preservation are going to be different this time.
“This time around, bond funds may no longer be the hedge against falling stock prices as they have been in the recent past,” Puplava said. “It’s been almost 37 years since we saw a bear market in bonds. … We could be approaching a similar period again, as deficits begin to explode in the latter part of this decade and most certainly in the next decade.”
How to Protect Yourself
This transition in bonds may not be linear, but present us with a series of storms.
If you are in bond funds and long-term bonds, it makes sense to begin to shift into shorter-term bonds to protect principle.
For investors who can afford it and who have portfolios that are large enough, it may make sense to go into a laddered bond portfolio with staggered maturities, so that every single year, bonds come due. That way, investors don’t lose any principle and can reinvest in higher-yielding bonds or other assets.
It may also be beneficial to consider what are called adjustable rate bonds, which pay interest that resets with rising interest rates every quarter or 6 months.
Puplava also recommends using a few of the best actively managed bond portfolios.
“The problem with bonds in bear markets is a bond bear market lasts a very long time,” Puplava said. “When they begin, they can last for decades. If you are in bond funds, you need to start taking evasive action now.”
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Article by Financial Sense