We just wrapped up our fall seminar series and based upon feedback it was a great success. Both venues – the Wolfe St Playhouse in Charleston and Emmett’s Brewery in Palatine – served as great places to not only deliver an important financial presentation but also as a great place to just hang out and visit with one another.
In case you missed one of the October seminars entitled “Rising Interest Rates: Should I Be Concerned?“, here is a quick recap of what you missed:
The Bond bull market may be over.
- The last 3 decades saw declining interest rates. Because of the inverse relationship between rates and bond prices, this created a nice tailwind for bond prices.
- With interest rates recently bouncing off historic lows and expected to gradually increase as the Fed tinkers with tapering their Quantitative Easing Program, these tailwinds are becoming headwinds.
- This doesn’t mean that bonds will necessarily have negative returns but expected returns should be significantly lower than the 8.5+% returns they have exhibited since September of 1980 when 10-Year Treasury rates peaked at 15.8%.
Bonds still play a vital role within an overall portfolio as do all of the asset classes.
- As a diversifier which creates lower volatility to the overall portfolio- bonds not only have smaller corrections than equities but have consistently held up during equity market corrections.
- As a capital preservationalist.
- As an income provider.
Traditional and major index (like Barclays Aggregate) bond funds may not be the best way to go. Make sure to ‘get under the hood’ of your bond portfolio and ‘check the fluids’.
- Duration (essentially the amount of time until a bond matures) – the bigger the duration, the more sensitivity the bond price will change. Because of this, consider reducing the overall duration of your bond portfolio.
- Consider adding floating rate exposure – one of the few subsectors within bond land that enjoys a rising interest rate environment given that they rely upon loans that reset in periods usually less than a year at the new current interest rate environment.
- High Yields – with default rates near historical lows, these securities can enhance an overall bond portfolio.
- Look to areas outside of the US – international developed and emerging bond markets can provide diversification and enhanced yields/returns.
- Utilizing low cost ETFs and mutual funds for the above exposure helps eliminate company-specific risk.
Use of multiple asset classes lead to non-correlation benefits that ultimately lead to better long-term results.
- Non-correlation leads to a tighter range of outcomes for the overall portfolio
- Tighter range of outcomes puts a smoothing effect on your return profile
- Smoothing effect leads to smaller downsides
- Smaller downsides lead to better geometric compounding
- Better geometric compounding leads to BETTER LONG-TERM RESULTS
- Note: Investor psychology studies and personal experience remind us that not everyone is a fan of non-correlation when stocks are roaring, but the fact is one cannot count on 20%+ stock returns year in and year out. Not to mention that the 30yr+ bond bull market may be over. One must look elsewhere for proper diversification, for real positive returns and for protection to the portfolio.
- The world has changed…and will keep changing.
- Don’t try to control the things you cannot, but take advantage of the things you can control.
- The markets cannot be controlled, but Asset Allocation can be. Asset allocation is the primary driver of returns.
- Make sure you are prepared for a rising interest rate environment or whatever environment is thrown your way by working with a wealth management professional firm like DWM.
What were you doing in 1981? A mere twinkle in someone’s eye? Attending school? Working? Married? Elise and I were buying our fifth house and taking on a 15% mortgage. The rate seemed pretty decent to us. 20-year Treasury bonds were yielding 15%, businesses were paying 21% for a “prime” lending rate, and inflation was in double digits. Many people thought we were living in Jimmy Buffet’s “Banana Republic;” where inflation and interest rates would continue at record highs for decades to come.
This was not to be. We had reached a turning point in 1981, where apparent trends started to reverse. In fact, inflation and interest rates decreased steadily for the next thirty-one years. Inflation has averaged less than 1.5% over the last five years and 20-year Treasury bonds yields reached a low of 2.11% last year. Now, it appears that we have a new, permanent change of direction-rates are beginning to rise. The thirty year bond bull market seems to have ended.
Until this year, bonds have provided a great place for investors to put a good share of their money. Performance has been very good and the risk has been low. Total return, as Brett pointed out a few blogs ago, is equal to the yield (interest paid on the bond) plus the change in value of the investment. Because bond prices increase when interest rates decline, bond investors have been rewarded with both their interest income plus an increase in market value for last thirty years.
From 1/1/2000 to 12/31/12, 20-year treasury bonds produced a total return of 7.6% per year. The S&P 500 had a total return of 2.4% over the same period. It’s no surprise that investors fell in love with bonds, not only for the excellent return but also for the lower risk and volatility. However, the experience of the last three decades in bonds is unlikely to continue.
It’s a shame, particularly for older investors.
Here’s a simple example. Let’s say that you own a bond paying 4% interest that matures in 5 years. If the interest rates for similar bonds decline by 0.50%,then the value of your bond is reduced by roughly 2.5% (0.50% decline x 5 years to maturity). Hence, your total return that year would be 4% interest income less 2.5% of price reduction. Hence, a net total return of 1.5%.
So, why would someone even own fixed income investments? The simple answer is that they still serve an important role in your portfolio. Fixed income has traditionally provided diversification and low volatility and should continue to do so. When equities rise, bonds won’t keep pace. But, when equities decline, fixed income historically advances. In addition, fixed income provides superior capital preservation qualities over other asset classes, including equities.
We believe in long-term investing and are known for not making “knee jerk” reactions. However, when there are major investment turning points, as we are seeing now, it is time to review portfolios with new proactive strategies in mind. This may include reduction of the allocation to fixed income, modifications within the fixed income asset class, and other techniques. Our DWM clients have seen a number of rebalancings focused on these matters in the last few months.
If you want to hear more, mark your calendars. DWM’s annual client educational update this year will focus on proactive strategies in a rising Interest rate environment. Our Charleston/Mt Pleasant event will take place October 23rd in the afternoon and our Palatine event will take place the afternoon of October 30th. We do recognize that the topic may, for some, be important but unexciting. That said, we can promise all attendees some pleasantries at the receptions that will follow. Be sure to watch for more details soon.