Daniel R. from Wichita, Kansas asks: The Federal Reserve seems to be on a path of raising interest rates, and I’m curious how that and other factors will affect the bond markets. Is now a time to stay away from bonds, or is it actually a time to invest?
First of all Daniel, congratulations to the Kansas Jayhawks for their #1 seed in the NCAA Basketball tournament. Not sure if you’re a fan, but it should be an exciting tournament for Kansas residents and fans!
On to investing. As you probably know, investing in bonds is not well-suited for short-term objectives or market timing. So, my very high-level response to your question is that you should invest in bonds only if your investment objectives and risk tolerance call for it. If you are looking to reduce volatility in your portfolio over time, and you have a goal of generating modest income over long stretches, then there is probably a place for bonds in your investment portfolio. If you want or need none of those things, then we’d have to take a closer look at whether bonds make sense for you at all.
Let’s talk about bonds in the context of rising interest rates, which you were correct to point out in your comment about the Federal Reserve. As long as the U.S. economy continues charting its current growth path – which we believe it will for 2017 – then it stands to reason that the Federal Reserve will raise interest rates maybe two or three times this year. As inflation expectations also build with the promise of lower tax rates and infrastructure spending, we could see upward pressure on longer term interest rates. Rising interest rates means falling bond prices, which could adversely affect performance and total return for investors.
But, that does not mean investors should steer clear of bonds. While rising rates could certainly impact bond prices in the short-term, they could also help boost longer term returns, assuming that the bond fund continues to invest the proceeds of maturing bonds into new bonds with higher yields. This would not only potentially boost returns over time, but also provide progressively higher levels of income for the portfolio.
In the current environment, however, I’d recommend bonds if your main desire is to reduce volatility in your portfolio and protect against the potential for equity market decline. In a sense, that kind of advice doesn’t change over time – in stocks’ worst times, bonds tend to hold up better, which limits the downside impact on your portfolio. In 2008, for instance, when the S&P 500 tanked -37%, the Bloomberg Barclays U.S. Aggregate Bond Index gained +5.2%. Having some bond exposure then, as will likely be the case in the next bear market, can help reduce the downside impact.
Disclosure