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Rocky Road Ahead for Bond Investors

Retirees need to guard their bond holdings against higher rates and inflation while squeaking out a decent yield—a tall order when many parts of the bond market look expensive.

For retirees with bond-heavy portfolios, 2016 came to an unsettling end.

The bonds that many retirees see as their safest holdings—Treasuries and high-quality municipals—sold off sharply after the U.S. presidential election. Expectations that the incoming Trump administration will boost infrastructure spending and cut taxes sparked inflation fears, and the 10-year U.S. Treasury yield jumped from 1.8% before the election to about 2.4% at the end of November. (Bond prices and yields move in opposite directions.) More pain came in December, as the Federal Reserve raised interest rates and central bankers signaled that they may hike rates three times in 2017.

Strategists see more bumps in the road ahead. If the new administration cuts taxes as expected, demand could cool for muni bonds, which are exempt from federal and most state and local taxes. And after a year in which the U.S. election and the United Kingdom’s vote to leave the European Union rocked the markets, upcoming elections in France and Germany promise more political uncertainty.

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Although strategists don’t see bonds crashing this year, investors need to buckle their seatbelts. “This year it will be pretty volatile—more volatile than last year,” says George Rusnak, co-head of global fixed income strategy at Wells Fargo. Retirees need to guard their bond holdings against higher rates and inflation while squeaking out a decent yield—a tall order when many parts of the bond market look expensive.

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For those who have been lulled by the 35-year bull market in bonds, the recent upheaval is a wake-up call. The plain-vanilla bond holdings that form the core of many retirees’ portfolios, those that hew closely to the Bloomberg Barclays U.S. Aggregate Bond index, appear poised for some pain. Over the past decade, the duration—or interest-rate sensitivity—of the aggregate index has increased roughly 33%, in part because U.S. Treasuries have accounted for a growing share of the index, according to Litman Gregory Asset Management. The index yield, meanwhile, has dropped more than 50% over the same period, to about 2.6%. Returns on the index “will be pretty paltry going forward,” says Jack Chee, senior research analyst at Litman Gregory.

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Your first step to prepare your bond portfolio for 2017: Rein in the interest-rate sensitivity of your core bond holdings. Expectations for higher economic growth and inflation this year mean that rate increases will be led by longer-maturity bonds, says Jeffrey Rosenberg, chief fixed-income strategist at BlackRock. Bonds maturing in two to five years are “a good strategy” for shortening duration, Rosenberg says.

Vanguard Short-Term Investment-Grade fund (symbol VFSTX) invests largely in high-quality corporate bonds, and its holdings have an average maturity of about three years. Another option: DoubleLine Total Return Bond fund (DLTNX), which invests largely in mortgage-backed securities. It has a duration of just 2.6 years, compared with more than five years for the typical aggregate bond index fund. (A fund with a duration of five years will lose roughly 5% if interest rates rise by one percentage point.)

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With inflation expectations ticking up, investors should also consider swapping some of their conventional Treasury holdings for Treasury inflation-protected securities, Rosenberg says. TIPS’ principal increases with inflation. While TIPS funds tend to have longer duration, Rosenberg says he is comfortable with that because he expects a large proportion of 2017’s rate increases to be driven by rising inflation expectations. Investors looking for less volatility can opt for a short-term TIPS fund such as Vanguard Short-Term Inflation-Protected Securities Index (VTIPX), which has a duration of 2.5 years.

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Although it may be tempting to juice your yield with lower-quality bonds, strategists urge caution. “Junk” bonds—high-yield bonds issued by companies with lower credit quality—were the best-performing fixed-income sector in 2016, with a 17% return. At today’s prices, though, strategists say investors aren’t getting paid for the risks they’re taking in these bonds.

Opportunity in Munis

One area of the bond market that does look like a relative bargain right now: muni bonds. Investors beat up these bonds after the election, on the assumption that tax cuts would dampen their appeal. But the sell-off looks overdone, says John Miller, co-head of fixed income at Nuveen Asset Management. The ratio of high-quality muni yields to Treasury yields, which usually stands around 85%, had climbed to about 100% as of mid January. “That looks unusually cheap,” Miller says.

What’s more, the proposed changes to corporate and individual tax rates may well be scaled back. If the top tax bracket falls to 33%—from today’s 43.4%—higher-income investors would still get an after-tax advantage from holding munis even if the historic gap between tax-free and taxable yields is restored.

Investors should focus on high-quality muni funds that don’t load up on interest-rate risk. Fidelity Intermediate Municipal Income (FLTMX) and T. Rowe Price Tax-Free Short-Intermediate (PRFSX) tend to avoid the riskier sectors of the muni market.

Looking overseas, developed-markets bonds don’t generate much excitement among strategists, as interest rates remain relatively low. Emerging-markets bonds offer more yield, but a stronger U.S. dollar makes it tougher for borrowers to pay back dollar-denominated debt.

Rather than pick through the fringes of the fixed-income market yourself, you can opt for a go-anywhere bond fund that has the flexibility to shift in and out of non–U.S.-dollar debt, junk bonds and other holdings. Loomis Sayles Bond fund (LSBRX), which can invest up to 35% of assets in high-yield bonds and up to 20% in stocks, has used such flexibility to build a strong long-term track record.

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