Investing in Bonds
BY: Daniel M. Savage
The wait is finally over! Just a few short weeks ago, the Fed increased the Fed Funds Rate for the first time in a year and only the second time since the onset of the financial crisis. That may leave you with a few questions:
- Why did the Fed raise rates by 25 basis points? The short answer is that the Fed now believes that U. S. economic growth and employment characteristics are sufficiently strong to warrant a rate increase.
- When will the Fed again raise rates and by how much? No one knows for sure, but most economists and financial analysts believe that it will be a gradual process over three or more years. One popular view is that 2017 will see two or three modest increases leading to a Fed Funds rate range of 1 to 1.25 percent by year-end. More importantly for investors, however, is the 10-Year Treasury, which has recently been trading around 2.5 percent. Many analysts predict little if any change over the next year.
- Should bond investors be concerned? Although rising rates can depress bond valuations and disturb equity markets, it’s not all bad news. The plus side is that rising rates are beneficial to long-term investors and savers over time. More importantly, as stated above, we believe that rate increases will be gradual. If true, this will help manage price volatility while offering slowly improving yields.
- What strategies might help make the best of this environment? First, remember why people typically include bonds in a portfolio: bonds provide stability when stock market volatility increases. Said differently, successful portfolio construction isn’t only about returns; rather, it’s also about diversification and downside protection. Second, don’t chase yield by excessively extending maturities. You can benefit by including short- and intermediate-term maturity exposure. Finally, laddering individual bonds (staggering their maturities) can be very beneficial when rates are still near historic lows. Yield-to-maturity is knowable and locked in at the time of purchase…provided the investor does not sell the bond prior to the maturity date.
In summary, focus on your overall investment goals and risk tolerance rather than on interest rates alone. Your exposure to bonds should be tailored to your personal financial goals in relation to your other investments.