Watch out for the bond bear market

As investors saw their nest egg deteriorate in the great recession of 2008, many moved their money into bond funds as a safe haven to protect their assets from decreasing stock prices. During this time, interest rates decreased to near zero and continued to remain at record lows. As a result, bond funds flourished. Investors became comfortable with bond returns even as they missed out on the continued stock market recovery.

The Federal Reserve already took action to raise the Fed Funds rate last December. Now with the anticipation of two more rate hikes by the end of this year and signs of inflation, many experts are predicting an increase in interest rates. As Warren Buffet said last year in an interview with CNBC, “I think bonds are very overvalued.” Although counterintuitive, when interest rates rise, the price of bonds decrease. As the price of bonds decrease, investors will see depreciation in their bond funds. In other words, they will lose money. So what should investors do in a time of rising interest rates?

Diversify

Every prudent investment advisor or competent financial professional is always going to recommend a diversified portfolio in all economic conditions. Many investors think only of market risk. However, not diversifying a portfolio can subject an investor to other risks often not considered such as interest rate risk and inflation risk. An investor who thinks they have a safe portfolio invested 100% in bonds may have a surprise just around the corner.

Short-term Bonds

There is an inverse relationship between bond prices and interest rates. As interest rates increase, bond prices decrease in value. There is also a direct correlation between the duration of a bond and the decrease in value when interest rates rise (volatility). A short-term bond fund that has a shorter duration than an intermediate-term or long-term bond fund will see a less significant decrease in value when interest rates rise. Therefore, investors can position all or a portion of their bond holdings in a short-term bond fund if they anticipate higher interest rates. Although this will not prevent a decrease in value during rising rates, the decrease should be less significant than longer term bonds.

Commodities

From the orange juice we drink to the energy that heats our home, commodities can be found all around us. Many low-cost commodity Exchange-Traded Funds (ETFs) allow the average investor access to commodities. Often as interest rates rise, inflation quickly follows. Commodities increase in value as inflation increases. Commodities have a high standard deviation (risk) and volatility, but can serve as a compliment to a portfolio in a rising interest rate and inflationary environment.

Stocks

After two years of near stagnant growth, many investors still cringe at the thought of investing in stocks. However, stocks continue their quiet recovery from the most recent correction. Stocks tend to have an inverse relationship to bond prices. Keeping a portion of a portfolio in stocks helps hedge against a potential decrease in bonds.

Inflation-Linked Bond

Inflation-linked Bonds, often called Treasury Inflation Protected Securities or TIPS, provide a hedge against inflation, but are not a perfect solution to rising interest rates. Even though the principal of each bond increases with inflation, the value of TIPS are still subject to a decrease in price as interest rates rise. As inflation follows rising interest rates, TIPS provide a place to protect assets against inflation. Although there are exceptions, TIPS should often be held in a tax-deferred account for tax purposes.

What Now?

With the Federal Reserve raising the Fed Funds Rate and the potential for increasing interest rates, now is a good time for investors to evaluate the asset allocation of their portfolio. Many investors may find they can hedge against rising interest rates and diversify their portfolio further by using some of the strategies outlined above. Other investors who think they have a very safe portfolio may be in for a big surprise.