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Craig Allen: Bond Market Perspective Suggests Sacrificing Current Income May Be Best Strategy

With all of the action in the stock market, it’s been tempting to focus solely on equities and to ignore the bond market altogether. However, recent action in bonds has been dramatic, to say the least. More to the point, those investors who have historically been able to rely on bonds for current income are now faced with a dual dilemma: where to find yield, and what to do with their bonds in a rising interest-rate environment.

Interest rates have risen significantly in recent weeks, with the 10-year treasury yield jumping about 100 basis points/1 percentage point, to 2.6 percent from 1.6 percent in just the past four weeks or so. Mortgage rates have also risen about the same amount, to 4.5 percent for the 30-year fixed from about 3.5 percent. The cause of this massive increase was the outflow of about $80 billion from bond funds and bond ETFs in the month of June. This is a massive exodus, and is actually larger in dollar terms than the selling we witnessed in October 2008, just after Lehman Brothers failed when the financial markets were in turmoil.

Bond prices move inversely (in the opposite direction) as bond yields/interest rates, so the selling pressure responsible for driving rates up resulted in substantial losses in bond prices. These losses were most acute in bonds with longer maturities — the area of the bond market favored by those looking for current income, since yields tend to be higher, the longer the maturity. (For a given move in interest rates, the longer the maturity, the larger the price change.)

Some investors looking for income bought alternative investments, including utilities, which explains why the utilities sector had advanced so far during the recent bull market (about 22.5 percent from the November 2012 low for stocks). Unfortunately, the utilities sector also suffered almost twice the drop of the overall market, falling about 13 percent from the May 22 all-time high for the stock market, while the Standard & Poor’s 500 fell 7.5 percent during the same time period.

The average dividend yield for the utilities sector is about 4 percent per year, which is slightly better than the 3.5 percent available in the 10-year treasury, but which pales in comparison to the 13 percent fall recently. Depending on the price at which a given investor purchased utilities, he or she could be upside down very easily, given the recent volatility in the market and in the utilities sector.

So, what is an income investor to do?

With the looming end to QE3 — the third round of quantitative easing, the Fed’s massive $85 billion per month bond-buying program designed to hold long-term interest rates artificially low — fixed-income investors, and particularly those dependent on the income generated from their portfolio for living expenses, face a formidable challenge: How to invest in a rising interest-rate environment without losing their shirt.

When the Fed decides to begin to taper off its bond buying, interest rates will certainly rise further. Clearly, even with the Fed’s relentless bond buying over the past nine months, bond prices have begun to fall because investors are selling bonds in anticipation of Fed tapering.

Rising rates pose a serious threat to portfolio values. Those holding long-term bonds are especially vulnerable in a rising-rate environment. While it is true that the investor can always hold bonds until maturity, no one likes to be in a situation in which their portfolio value has fallen dramatically. Falling bond prices put the investor in a situation where, should they need to sell for any reason, they will likely be forced to take losses.

To avoid this very real possibility, bond investors should consider shortening maturities, meaning selling bonds with longer maturities and replacing them with bonds that have shorter maturities of five years or less. Staggering or laddering the portfolio with maturities from one year to five years is a simple way to spread the risk of the portfolio among these various maturities, while also placing money so that each year some bonds will mature, allowing for reinvestment at (hopefully) higher interest rates, once rates have moved up significantly.

While current income will certainly be lower if the investor shortens maturities, this should be a somewhat temporary situation. After a one- to three-year time frame, rates should have increased enough so that maturities can begin to be lengthened, resulting in an increase in overall income from the portfolio. The short-term loss of some income should pay off handsomely through the avoidance of losses in the value of the long-term bonds held previously.

While it is not clear when exactly the Fed will begin to taper its bond-buying activities, we know they will do it eventually and in the near term. Indications from Fed members are that tapering will begin sometime before the end of 2013 and that all Fed bond-buying activity will cease by mid-2014. It is inevitable that rates will rise significantly as a result, and that long-term bond prices will fall.

Bond investors will benefit from being proactive and making appropriate changes to maturities before rates have risen.

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here to read previous columns or follow him on Twitter: @MPAMCraig. The opinions expressed are his own.

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