Fed Watch

The entire investing world will have its eyes on The Federal Reserve tomorrow as they hold a much anticipated meeting where they are expected to raise the short term Federal Funds Rate for the first time in over 9 years.

I would like to use this edition of The Short Squeeze to look at what rising interest rates mean for our clients' bond portfolios. I found this recent piece in Barron’s authored by PIMCO that touched on some key points of bond investing in a rising interest rate environment that I wanted to share.

Before diving into the implications of what it means to own a bond portfolio in a rising interest rate environment we believe it is important to answer the question, "Why do we even own bonds?" We feel that owning bonds is key competent to building a diversified portfolio of securities. To quote the article, “bonds have historically provided capital preservation, income and growth, and low-to-negative correlations to equities – essential goals for many investors.”  For clients at or near retirement, owning bonds typically provides a buffer against the volatility of stocks as we have seen in recent weeks. “As Figure 1 shows, bond declines have been dramatically less severe and usually short-lived.”

With that being said, let's dive into the implications of owning bonds in a rising interest rate environment. As we all know, the price of a bond moves inversely to interest rates, meaning, as interest rates rise, bond prices should fall. However, it’s important to remember that as you receive interest income from bonds you are able to reinvest into a gradually rising interest rate environment which can help build long-term income growth. “An increase in a bond portfolio’s income also helps to offset the negative impact on its price – often quite quickly, as Figure 2 shows. Over time, rising income should actually provide a return advantage.”

Now some may say if rates are going higher in the near future, why don’t I just park my money in cash? Even if the Fed hikes interest rates by 0.25%, by being in cash versus a diversified bond portfolio, that money is still losing purchasing power every day after accounting for inflation. “Bonds almost always generate a higher rate of return than cash or money markets, and though their prices may fluctuate, the compounding effect should work to an investor’s long-term advantage, as Figure 3 shows.”

We believe another powerful tool to have in a rising interest rate environment is active management. When you passively invest in a bond index there is almost zero flexibility in the portfolio; your performance will track that chosen index. Active management, especially in a rising rate environment, gives an active manager flexibility to alter the duration of the portfolio to hedge against rising rates, or even purchase securities that have historically done well in rising rate environments. 

Until next time. 

—Brett C. Hixon, CFP®

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Opinions expressed in the attached article are those of the author and are not necessarily those of Raymond James. All opinions are as of this date and are subject to change without notice. Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. Holding bonds to term allows redemption at par value. Diversification does not ensure a profit or guarantee against loss. Investing involves risks and you may incur a profit or loss regardless of the strategies employed. Past performance does not guarantee future results.