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Most investors are now accustomed to changing stock markets, but they may not be as alert to changing bond markets, especially because bonds have been in a bull market for the last three decades. Our firm’s tagline, Because Markets Change, applies to bonds as well as stocks.
Bond markets are tied most closely to interest rates – bond prices move inversely to interest rates and when rates fall, bond prices rise. Interest rates change over time due to economic conditions, Federal Reserve policy and other factors - and this in turn leads to changes in the bond markets.
Treasury Yields - 1990 through 2013
Interest rates gained steadily from the mid-1970s until 1981, after which rates declined for 30 years, and some fear we will eventually return to those nosebleed rates of 30 years ago and experience an accompanying fall in bond prices. But this may be simply because most investors only remember periods of rising or falling rates. A longer look back shows that the ‘70s and ‘80s may be the historical anomaly; there were decades when yields pretty much moved sideways, bouncing around between 2% and 5% in the first half of the 20th century. (Treasury yields are considered a proxy for interest rates.)
Today’s historically low rates aren’t likely to persist over the next 30 years, but no one knows how much rates might rise or how quickly they might rise. It’s worth noting that the historical median level for interest rates over the long term, 4.1%, is double the current level. The effect of rates doubling over the course of a couple of years would be very different than if they were to double in just a couple of months.
Adapting to Changing Bond Markets
What can fixed income investors do given that they can’t know what interest rates will do in the future? When rates rose, most bonds struggled, and this led some investors to question whether bonds are still a good place to invest at all. We believe that bonds are still an important part of most investors’ portfolios: most stock investors need some exposure to bonds to help buffer the volatility of stocks, and investors who hold both stocks and bonds may be more likely to stay invested long enough to achieve their long-term investment goals.
We believe an active approach to bond investing can enable us to reap many of the benefits of fixed income instruments, while potentially avoiding some of their vulnerabilities. Instead of avoiding bonds, we seek to adapt to changing bond markets. Our FundX Flexible Income Fund (INCMX) began in 2002 and it has adapted to over a decade of changing bond markets.
We don’t attempt to forecast changes in the market. Instead, we reposition our portfolios into different areas of the bond market. Different kinds of bonds do well in different market environments, and some areas of the bond market hold up better than others when interest rates rise.
Opportunistic, but Risk Averse
The FundX Flexible Income Fund (INCMX) has performed well during the years when rates were falling or stable, and we believe it also has the potential to capitalize on a rising rate trend. It can invest in floating-rate funds, Treasury Inflation-Protected Securities (TIPS), inverse funds, foreign bond funds and market-neutral or hedged equity funds, all hold the potential of offering gains during various kinds of market conditions, in spite of rising rates.
In more challenging market conditions, INCMX may also be entirely invested in ultra-short-term bonds. So we have many and varied tools at our disposal for the road ahead.
We can’t know today what the future will hold for interest rates: rates may rise, like they did in the second quarter, or they may continue to move in a trading range. But we do know that bond markets will change over time, and we believe an active approach to fixed income that can take advantage of different kinds of bonds will be better able to navigate through these changes.
Examples of How Different Bonds React to Interest-Rate Changes
Long-term bonds (12+ year duration) are most susceptible to interest-rate fluctuations, and because of the greater risk they pose, we have avoided them altogether in the past decade.
Intermediate-term bonds are more sensitive to interest-rate changes than shorter-term bonds, but for the past three or four years investors have been well paid for that extra risk. Our Flexible Income Fund’s portfolio has taken advantage of the yields offered by intermediate-term funds in recent years.
Short-term bond funds are generally more insulated from interest rates. Generally, the shorter the average duration of a bond fund, the less the fund’s NAV will fluctuate with interest rates. The trade-off for the stability of short-term bond funds is that these funds offer very low yields. Nevertheless, if we are in a rising-rate environment, we could shift our portfolio largely into bonds with shorter maturities.
Performance data quoted represents past performance; past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance of the fund may be lower or higher than the performance quoted. Performance data quoted current to the most recent quarter- and month-end may be obtained by clicking here.