Income Investors, Don't Fret About Higher Interest Rates

The vast majority of investing seers were betting their right arms one year ago that interest rates would rise enough in 2014 to inflict severe pain on holders of bonds and other income-oriented investments. That was an epic misjudgment, and we’re glad to say that you read no such dire warning here.

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As it turned out, 2014 was wonderful for holders of bonds and other income investments. Over the past year, the yield of the benchmark 10-year Treasury bond dropped from 2.6% to 2.3%. Because bond prices move opposite to interest rates, long-term government debt returned 13.1% over the past year (returns and yields are through October 31). Municipals went wild, propelled by improved credit quality and tight supply; they returned 12.6%. Real estate investment trusts and utilities also performed spectacularly. Energy income securities prospered until oil prices slumped. Junk bonds essentially earned their coupons, returning 5.9%.

For the coming year, expect interest rates to rise slightly and returns to moderate. But there’s no need to panic. The near-absence of inflation, the powerful dollar and fair U.S. growth juxtaposed against economic weakness and disorder almost everywhere else keeps U.S. income investors in a sweet spot. “The basic story is that the U.S. economy is better than any in the world, so U.S. financial assets should do better than any others,” says Krishna Memani, chief of fixed income for Oppenheimer Funds and one of the few pros who got 2014 right.

You might think that a revived U.S. economy would send rates here soaring. But instead of jacking up borrowing costs, a healthy U.S. attracts cash from all over the world, helping to restrain rates. Foreigners are gorging on Treasury debt with little regard to yield, figuring that getting paid in a robust currency from a stable country is a safer and potentially more rewarding bet than investing at home.

At the same time, other anti-bond arguments keep falling apart. Investors seem unconcerned that the Federal Reserve has voted to end its massive bond-buying program. As for lifting short-term rates, the next step in returning to a more normal monetary policy, it’s unlikely that the Fed will do anything until summer at the earliest.

Rate outlook. I grant that as yields have come down, the risk of owning bonds has gone up. For a look at what you might lose if rates reversed course, I commend to you What Will Higher Rates Do to the Kip 25 Bond Funds?. Figure on 10-year Treasuries yielding between 2.25% and 3.25% over the coming year. Given that rates are near the bottom of that range, you would probably lose money if you bought a long-term bond today and sold it in 2015. But much of your portfolio’s performance will depend on the kinds of bonds you own and their maturities, which should be a lot less than 10 years. I favor middle-of-the-road bond funds—such as Fidelity Total Bond (FTBFX), a member of the Kip 25—and medium-maturity municipal bonds, as well as REITs for more aggressive investors.

I close with another dose of reassurance: If the Fed were to embark on a vigorous rate-hiking campaign, such a move would surely crush any inflation anxiety. That, in turn, would lessen the likelihood of long-term rates rising significantly. This is the pattern Memani expects. So does the team at Metropolitan West funds, where the talk is of a “flatter yield curve over time.” In plain English, that means you would finally earn more on CDs, money market funds and short-term debt. But you wouldn’t lose all that much on long-term government and corporate bonds.