What Should Bond Investors Do Now?

As the U.S. stock market continues to defy investor expectations by scaling new heights, the U.S. bond market appears to be defying the Federal Reserve, which is counting on interest rates to rise. The Fed has clearly signaled that it wants to "normalize" interest rates, which have been hovering near their historic lows for several years; yet the bond market has barely raised an eyebrow at the certain prospect of future rate hikes.

This is unsettling to investors who hold bonds in their portfolio, or who are considering bond purchases, because they know the only place for interest rates to go is up; and, when that happens, the price of their bonds will go down. The rightful question in their minds is "Why would anyone want to hold or buy bonds when they know their prices will go down?"

The simple and logical answer to the question is they wouldn't, and it would make more sense to wait to buy bonds or consider selling bonds and buying them back when they are cheaper. Except it really isn't that simple. While the odds strongly favor an increase in interest rates in the future, no one can predict when it will happen or the extent of the increase. Interest rates have been in a long, slow decline for more than three decades. Consider the number of times just in the past decade when interest rates were expected to rise (2009-2011 and 2013-2014), and they didn't. Consider also the periods in which interest rates did increase and by how much. Interest rate increases of any significant extent or duration have been extremely rare in modern history.

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Taking Action Now Could Increase Portfolio Risk

The point this raises is any action taken now to avoid an interest rate increase or capitalize on a decrease in bond prices is tantamount to trying to time the market, which we know doesn't turn out well for most investors. In fact, when it comes to the stock market, the average investor has underperformed Standard & Poor's 500-stock index by an average of nearly 5% over the last 20 years,, according to data from financial markets research firm Dalbar. Any attempt to time the bond market would invariably result in similar miscalculations simply because no one can predict when and how much interest rates will rise.

That hasn't stopped our clients from asking if they should buy, sell or hold bonds right now. Given the current interest rate environment, it is not an unreasonable question, but it can only be answered by asking another question: Why do you own or want to own bonds in the first place? The answer to that question will provide the rationale for the answer to the first question.

If You Own Bonds for the Income…

If your objective is to collect interest for income, and your current bond income is sufficient to meet your needs, you probably shouldn't do anything. The movement of bond prices in the secondary market will not affect your income. If you plan on holding your bonds until they mature, then the direction of interest rates really doesn't matter.

However, if you want to take advantage of higher interest rates when they occur, you could consider implementing a bond ladder strategy. The objective of a bond ladder is to own bonds of increasing maturity and yield that come due each year over a set period of time. In a rising interest rate environment, as each bond matures, it will be replaced with a higher-yielding bond. Whether interest rates are rising, falling or flat, a bond ladder of high-quality bonds will continue to produce a reliable cash flow. This strategy can be achieved with individual bonds or bond index funds with varying average maturities. (If bond funds are going to be used, it's important to invest in ones that mature; otherwise, liquidation return is unknown.)

If You Own Bonds for Portfolio Stability…

For most long-term investors, bonds provide their portfolio with stability as a counter to the volatility of stock prices. Historically, bond prices trend opposite of stock prices. Bonds can only provide portfolio stability if you own them, so, to sell bonds now would defeat your purpose. It's okay to have bond prices move up and down because that is what provides the stability, and during bond price declines your portfolio is still receiving bond interest, which is a stabilizing factor. Bonds should only be sold as part of portfolio rebalancing to fine-tune your risk exposure.

If You Own Bonds for Total Return…

Bonds do have the potential to provide both income and appreciation, which combine for total return. If your objective is to maximize your total return by buying and selling bonds, now probably wouldn't be a good time buy them.

However, you also have to consider the opportunity cost of not owning long-term bonds while waiting to buy them when interest rates are higher. What is your alternative? Keeping your money in short-term bonds or fixed-yield cash equivalents? How many basis points of interest income will you be giving up while waiting? Will rates increase fast enough and high enough to offset the cost of waiting? If you can't definitively answer those questions, you are simply gambling on circumstances over which you have no control.

Worrying About Higher Interest Rates Doesn't Pay

Bottom line: Bond investors who base their actions purely on the prospect of rising interest rates are engaging in market timing that has a very small chance of succeeding. While we know interest rates will rise in the future, we can't know when or how high. Rates would have to rise significantly to offset the cost of waiting to own high-quality bonds again, and the probability of such a rate increase is very low. Investors who have a long-term investment strategy linked to specific return objectives have the least to worry about, because they can expect the bond portion of their portfolio to do what it is expected to do over time.

Craig Slayen is a principal at Cypress Partners., a financial planning and investment management firm in the San Francisco Bay Area.

Pete Woodring, a partner with Cypress Partners, contributed to this article.