For many years “model portfolios” have provided a handy roadmap for investors as they balance risk and reward. Younger investors are told to build portfolios with a heavy weighting in stocks, and then gradually tilt their holdings toward fixed income as they get older. The sweet spot for middle-age folks has been the classic “60/40” model—i.e. 60 percent in equities and 40 percent in bonds.
Trouble is, bonds may not be the low-risk option they’ve been in the past. After a three-decade bull market for bonds (which pushed bond prices higher and bond yields lower), that cycle is starting to reverse course. The yield on 10-Year Treasuries has risen from 2.14 percent in June to a recent 2.83 percent. In response, bond prices are moving lower.
And signs point to a further hit to bond prices due to a trifecta of factors comprising expectations for more Federal Reserve action on boosting short-term interbank lending rates, the unwinding of the quantitative easing bond buying program, and recent multi-year highs in a key inflation gauge.
The upshot is that many bond funds will lose value, erasing any benefits offered by their modest yields.
“Duration is the key metric for advisors to be watching these days,” says Todd Rosenbluth, director of ETF and mutual fund research at CFRA. Duration measures a bond's sensitivity to changes in interest rates. Typically, the longer a bond has until maturity, the more its price will fluctuate as interest rates change.
High-duration bonds funds are off to rough start in 2018. For example, the Vanguard Extended Duration Treasury ETF (EDV) is down 4.6 percent and the iShares 20+ Year Treasury Bond ETF (TLT) is off 3.5 percent this year. And they might suffer further losses during a rising rate environment in the years ahead.
In contrast, the Sit Rising Rate ETF (RISE), which uses Treasury futures and options to produce the equivalent of negative 10 years of duration, has risen an impressive 7.6 percent over the past year. That more than offsets the somewhat stiff 1.00 percent expense ratio.
But not all are convinced that long-term interest rates are poised to move meaningfully higher. Karen Schenone, a BlackRock fixed-income strategist focusing on iShares fixed-income ETFs, notes that while bond futures contracts are pricing in a 66 basis point increase in short rates by year-end (suggesting two to three fed rate hikes), “the long end is only pricing in another nine basis point increase,” she says.
Schenone concedes that inflation “is the wildcard in the outlook.” The consumer price index rose 2.4 percent in March, the biggest increase in a year. But the strategist doesn’t think that prices will rise much at a faster pace. “We’re seeing little inflationary pressure,” she says.
For investors who want to hedge against the possibility of markedly higher short- and long-term interest rates, the iShares Floating Rate ETF (FLOT), which charges a 0.20 percent expense ratio, may be a savvy choice. The fund holds variable rate bonds that are pegged to the London Inter-bank Offered Rate (LIBOR), so their income streams will grow as LIBOR rises, even as the fund itself should see little change in value.