Here are steps to consider that might help you avoid losses.
With interest rates scraping bottom, the question is no longer if they will rise, but when. Given the soft spots in the economy and in moribund corporate spending, a return to the double-digit bond yields and inflation of the early 1980s appears unlikely.
But there are some warning signs pointing to an upswing in interest rates in the next year or two. Treasury bonds could come under pressure later this year as the budget deficit forces the federal government to issue more securities. The likelihood of lower oil prices now that the war in Iraq is more or less over will help stimulate the economy. And bond prices have risen so much over the last few years, and have trounced stocks by such a wide margin, that the potential for price deterioration far exceeds the possibility of further gains.
In this unsettled environment, financial advisors face the dilemma of putting fixed-income allocations to work, or protecting current positions, at a time when the three-year-old bond market bubble could pop. The prospect of falling bond prices has some advisors re-thinking old strategies and paying more attention to a side of the portfolio that once required minimal maintenance.
"We haven't faced this kind of interest-rate environment in quite awhile, and some younger advisors have never faced it at all," says Jeff Street, a CFP licensee with Street Financial Services in Methuen, Mass. "Investing in bonds can no longer be an afterthought to the stock market. We need to have keener, more thoughtful strategies in place to protect our clients."
With money market rates still well under 1%, letting fixed-income allocations sit on the sidelines isn't an option. From shortening maturities, to increasing their use of dividend-paying stocks, to exploring new types of fixed-income securities, financial advisors are drawing on a variety of investment products and strategies to do battle with the interest-rate beast. .Here are a few of them:
Making the move to individual bonds. Street, who has been in the financial services business for 15 years, has always relied on mutual funds for his fixed-income allocations. Now, he's adding unit investment trusts and individual bonds to the mix for clients who want the assurance that they will receive their principal at maturity, regardless of what happens to interest rates. "It used to be a no-brainer to just let the fund manager do all the work," he says. "But even the best manager will have a hard time protecting principal if interest rates go up."
Bradley Teets, a CPA and CFP licensee in Punta Gorda, Fla, says his preference for individual bonds over bond funds has grown stronger as the prospect of rising interest rates increases the possibility that bond fund investors coming into the market could suffer a setback. He typically creates a laddered-maturity portfolio for clients with bond allocations of $100,000 or more. "If you invest less than $20,000 per bond, the bid-ask spread on corporate issues just becomes too high," he says. "I also stick with new issues because they are simpler to buy. And because many older bonds sell at a premium now, clients would get back less at maturity than what they paid on the secondary market. That doesn't sound very appealing to most of them."
Teets recently assembled a laddered portfolio for a retiree that incorporates a diverse range of maturities and credit qualities. The shortest rung on the ladder is a one-year certificate of deposit yielding 1.65%, and the portfolio has at least one bond maturing each year over an 11-year period. It contains a mix of investment grade corporate notes and government agency issues, as well as BBB-rated notes from General Motors Acceptance Corporation (GMAC) yielding 6.15%.
Other advisors are using bonds with creative structures, including those designed to withstand a rising interest-rate environment. Alex Sugar, senior managing director at the Boston office of Bear Stearns, taps the government agency issue market with "step bonds," which change their interest payments in several stages. He recently purchased a step bond for a client issued by the Federal Home Loan Bank (FHLB), which matures in 2010. During the first two years, the bond pays a 3% rate of interest. The rate goes up to 5% during the next three years, and rises to 7% until maturity. Although the bonds are callable, that issuer protection probably won't kick in unless rates fall below what the bonds are paying.
Sugar also buys floating-rate bonds, or "floaters." The rate on these corporate issues, which is usually pegged to the London Interbank Offered Rate (LIBOR) or Treasury bills, changes periodically. For older retired clients, he often recommends intermediate-term corporate notes that give heirs the option to "put" the note back to the issuer at par plus accrued interest when the original owner dies, even if interest rates have risen since the purchase date. Although both types of securities offer protection against increases in interest rates, their yields are usually slightly lower than fixed-rate securities of the same quality and maturity.
Replacing bonds with high-yielding stock alternatives. Although Teets still uses bond funds for investors with under $100,000, the current environment has prompted him to recommend that they steer some of their fixed-income dollars toward high-yielding equity alternatives, such as master limited partnerships (MLPs). These share some characteristics with real estate investment trusts (REITs), trade like stocks and are often associated with companies in the energy industry. They carry yields in the 6% to 10% range, much of which is tax-deferred. Preferred stocks and REITs are also on his list of bond substitutes. "I know these investments carry equity risk," he says. "But you also have to consider the very real risk of losing principal in a bond fund in this environment."
Street says that a few clients have balked at the notion of substituting stocks for bonds to achieve a desired income level. "In those cases, I show them charts of what happened to bond prices during times of rising interest rates, such as the early 1980s, and compare that to the possible fluctuations in dividend paying stocks," he says. "Many of them just don't realize how volatile bond prices can be."