Caution! Bonds Can Suffer Losses, Too

As the economy recovers, the bond market is susceptible to changes from interest rates and other factors. John P. Culhane, of Midland States Bank, suggests ways to protect your bond-related investments.

Following the stock market crash in 2008, investors exited stocks and purchased bonds and bond funds to reduce their perceived risk. Many investors need to be reminded that their seemingly safe and secure bond holdings can also suffer losses. For most investors, this will occur when – not if – interest rates rise enough to erode the value of their bond holdings.
The Federal Reserve Bank, through its various monetary policies used to stimulate the U.S. economy over the past few years, managed to lower interest rates to record lows. With the return on short-term investments functionally at zero, and bond yields in many market segments at record lows, investors have been in a desperate hunt for yield and income. Many of these investors took on additional interest rate risk and credit risk to earn incremental yield, focusing on income, without regard to the source or risk. As a result, these investors may not be prepared for the possibility of price volatility and market value losses that can occur from increasing interest rates.
In very simple bond math, as interest rates rise, the price of bonds will fall. When the level of general interest rates was higher a few years ago, the coupon income earned from holding a bond may have been enough to offset the drop in the market value of a bond when rates increased. In today’s market environment of low interest rates, the coupon income investors receive may not be enough to offset the decline in market value.
Here are a few tips to insulate your portfolio or decrease the impact from rising interest rates.
Reduce the average life or maturity of your bond holdings. The shorter the term to maturity, the smaller the price volatility. Add securities with shorter terms to maturity.
For risk adverse investors, purchasing less than one year to maturity FDIC guarantee bank insured CDs offers some incremental value over comparable term capital market products. Current CD yields may not be attractive, but if interest rates increase, the proceeds can be reinvested for higher yields.
Money Market Funds are paying virtually next to nothing for investors to park their money. However, mutual funds yields are variable and will increase, though not in lockstep, when short-term rates eventually increase.
Floating Rate Mutual Funds pursue total return consistent with current income and low interest rate volatility. These funds invest in securities and products whose interest income will increase or decrease with changes in market interest rates.
Ultra-short or limited duration mutual funds are designed to be less sensitive, but not immune to interest rate changes. This fund category is often sold as a money market fund alternative, since assets are invested in short-term securities ranging from three months to a year. While these funds offer lower price volatility, investors need to be accepting of and comfortable with the credit composition and types of securities that are the basic structure of these funds.
A Barbell portfolio strategy, buying both short- and intermediate-term maturity bonds and funds, can provide a reasonable income strategy that should help to limit, but not eliminate, price declines caused by interest rate spikes. While the intermediate term bond or fund would suffer a market value loss when interest rates increase, the short-term portion can be reinvested at higher yield levels.
A Laddered portfolio strategy, using an equal amount of 1- through 5-year term securities, can also help to shelter the portfolio from losses. As time passes, the proceeds from maturing shorter-term securities can be reinvested into 5-year term securities. This rolling maturity and purchasing process should not be expected to fully protect your portfolio, but it will provide an increasing income stream in a rising rate environment.
Increase credit risk exposure to increase coupon income. A portfolio structure that utilizes credit risk does achieve some incremental yield, but care should be taken to manage the incremental risk.
If appropriate, an allocation of short-term investment-grade municipal bonds in the Barbell or Laddered portfolio could improve after tax earnings. However, these securities are just as susceptible to value swings from changes in interest rates.
Be aware of the difference between buying a specific bond and a bond mutual fund. A bond will eventually mature, but a bond fund does not.
If you haven’t already, consider diversifying your portfolio with high-quality dividend paying stocks.
As always, bond market investors should have a strategy to provide an adequate income stream while managing market price volatility. Now is the time to review your holdings with a trusted financial advisor, before interest rates materially change and damage is already done.

John P. Culhane, Chief Investment Officer at Midland States Bank, has provided progressive financial management and leadership expertise for more than 30 years. He holds Master of Business Administration, Master of Science in Finance and Bachelor of Science in Finance degrees from Northern Illinois University in DeKalb, has achieved designation as a Certified Financial Analyst®.