Rate outlook poses complex risks for bond investors
With interest rates near all-time lows, bond investors are between a rock and a hard place. At a MarketWatch Investing Insights event, bond experts discuss the risks and strategies investors should be thinking about now.
Bond laddering is a technique for generating current income while reducing the effect of rising and falling interest rates on the fixed-income portion of your portfolio, according to William O'Donnell, the head of U.S. Treasury strategy at RBS.
O’Donnell was among the panelists at the MarketWatch event, as was Lee Munson, founder and chief investment officer of Portfolio LLC.
“I look at a bond ladder as a very reasonable and appropriate way to manage your fixed-income portfolio,” O’Donnell said in a recent interview.
In essence, the technique calls for building a portfolio of fixed-income investments (CDs, annuities, bonds, ETFs, and the like) that mature at different dates along the so-called yield curve — the curve that shows interest-rate yields based on maturities — based on your outlook for interest rates.
If you are unsure whether interest rates might rise or fall in the future, you might put your cash in equal amounts in a number of fixed-income investments — for example, one-third in short-term bonds, one-third in intermediate-term and one-third in long-term bonds. Then you simply roll the maturing bonds back into short-term fixed-income investments.
If, on the other hand, you think interest rates might fall, you would do the exact opposite and invest a larger percentage of your portfolio in long-term fixed-income investments, and a much smaller percentage in short- and intermediate-term fixed-income investments.
At a MarketWatch Investing Insights panel discussion, William O'Donnell, head of U.S. Treasury strategy at RBS Securities Inc., talks about how investors can best manage their bond investments in a time of ultralow interest rates.
Investing exclusively or largely in long-term fixed-income investments subjects you to interest-rate risk — the risk that the value of your bonds will fall should interest rates rise.
Keep in mind, however, that investing exclusively or mostly in short-term fixed-income investments in today’s market subjects you to inflation risk. That’s the risk that the value of your investment declines as inflation shrinks your purchasing power. (Right now, you’re earning a negative real rate of return on short-term fixed-income investments; the real rate of return is the nominal interest rate minus the rate of inflation.)
With a bond ladder, you are essentially trying to manage many of the risks associated with investing in fixed-income securities, including interest-rate risk, inflation risk, and reinvestment risk. Reinvestment risk is the risk that you’ll have to reinvest in lower yielding investments when your fixed-income investments mature in a falling interest rate environment.
Fed adds to the risk
Managing those risks is made even more difficult given the Federal Reserve and its efforts to bolster the economy.
“The difficulty with the U.S. fixed-income market right now is that it's being heavily manipulated by the Fed and this is all under what the Fed refers to as the ‘portfolio balance’ channel,” O’Donnell said. “They basically want to push base Treasury rates down to levels that force people to go into riskier asset classes in search of more yield or return.”
“And it's worked handsomely well, which is why the stock market keeps going up every week, and why Treasurys are unwilling or unable to sell off in the face of stronger economic data,” he said.
“The Fed is removing the net supply of Treasurys from the market through their quantitative easing, as well as removing duration from the market through ‘Operation Twist,’ keeping real rates negative in many cases,” he said.
Here’s the question that fixed-income investors must answer when building their bond ladder: “When is the Fed going to remove their guiding hand and let the rate markets normalize?” said O’Donnell.
For the record, O’Donnell doesn’t expect the Fed to remove its guiding hand before the end of the year. The Federal Reserve, meanwhile, tipped its hand to the contrary. According to the minutes of its policy meeting in March, members of the Federal Reserve Board are not interested in another round of quantitative easing. Read: Fed less interested in bond buys.
Of course, it’s even more complicated than all that.
Besides making the right guess about the direction of interest rates, you have plenty more to consider, including which fixed-income investments work best for you in building a bond ladder. The choices include (but are not limited to) CDs, income annuities, corporate bonds, government bonds, municipal bonds, junk bonds, or mutual funds and/or ETFs that invest in fixed-income securities.
If you plan to purchase individual bonds, consider whether you have enough money to do so. Some experts recommend that you have at least $100,000 to build an adequately diversified portfolio of individual bonds. Also, if you plan on building a bond ladder with individual bonds, you have to consider default risk.
You can reduce the risk of default by building a bond ladder with ETFs or mutual funds. Guggenheim and iShares are among those firms that offer a lineup of target maturity date fixed-income ETFs.