Bonds vs Bond Funds in a Rising Rate Environment
Interest rates have been on the rise for some time now as the Fed has indicated it is pulling back from years of monetary stimulus. With the market expecting additional interest rate hikes over the next 12 months, many investors are wondering how rising rates may affect their fixed income portfolios. Two questions (and answers) we have been receiving from clients are:
Q1: Why do I have an allocation to fixed income in a “rising rate environment”? Don’t prices fall as yields rise?
A: It is our opinion that each investor should work with their advisor to understand the purpose of their long term asset allocation – (i.e., the mix of protection oriented assets vs growth assets). We believe our chances of success are optimized by maintaining consistent exposure to your long-term asset allocation targets. An important point on fixed income returns from this perspective can be seen in the attached article from Schwab. According to Schwab, “since 1976, more than 90% of the total return for a broadly diversified portfolio of U.S. investment-grade bonds (represented by the Bloomberg Barclays U.S. Aggregate Bond Index) has come from income payments rather than a change in price.” Investors with a long-term focus should be much more concerned with receiving coupon payments (and maintaining exposure to these payments) rather than focused on short-term price fluctuation, which is very difficult to predict. We can see the consistent positive affect from these coupon payments across different interest rate regimes below.
Q2: What’s the best format to own fixed income? Should I use bonds or bond funds?
A: Each investor should work with their advisor to understand the various pros & cons to owning fixed income through direct purchases of bonds or by using bond funds. Both options can be appropriate and should be considered when structuring the portfolio. This may come as a surprise to some investors who have written off bond funds for reasons like rising interest rates. The attached article from Schwab highlights some of these misconceptions and can serve as a good starting point to better understanding your bond portfolio.