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We recently spoke with a shareholder who uses our Upgrading investment strategy for the equity component of her portfolio and a laddered bond approach for the fixed income part of her portfolio. This investor was considering reinvesting the proceeds from maturing bonds into intermediate- and long-term bonds and perhaps adding to stocks. But she wondered if it made sense to keep buying bonds that will mature a decade from now given that rates are at historic lows. “I am concerned that in the last two years yields have been lower and I am locking in those lower yields for 10 years. I am watching closely as I believe interest rates will remain at current rates in the near term, but eventually must rise.”
Many investors, like the shareholder we spoke with, worry about how rising interest rates could affect their bond investments. Prices on long-term bonds (as measured by the Barclays U.S. Long Government/Credit Bond Index) have risen strongly over the past few years, appreciating almost 20%, but investors who hold these bonds to maturity could see these gains disappear. Anything beyond a modest or gradual increase in rates could turn the gains on these positions into losses unless the bonds were held to maturity.
If bond investors opt to sell their longer term bonds, what should they buy with the proceeds? Bond investors who hold bonds until maturity typically reinvest the proceeds in new bonds that have higher credit ratings. In the current environment of low yields and heavy demand, bond defaults are rare. But one lesson from the recent credit crisis is that relying on credit rating agencies can prove hazardous to your financial health.
One solution for bond investors who are concerned about rising interest rates is the Flexible Income strategy that we use to manage the FundX Flexible Income Fund (INCMX), a dynamic portfolio of bond funds.
Investors who hold long-term bonds, which are more susceptible to interest rate risk, could effectively shorten their duration by shifting to the FundX Flexible Income Fund. (INCMX’s duration is currently less than 4 years).
Diversification is another potential benefit. Bond investors typically hold just five to ten bonds in a portfolio and are often concentrated in just one area of the bond market. But if default rates increase when rates rise or money tightens, a concentrated bond portfolio could suffer a large loss if an individual bond is downgraded or goes into default.
Bond funds, on the other hand, are diversified over many issues, lowering the impact of individual bond defaults. And a portfolio of bond funds, like the FundX Flexible Income Fund, is diversified over a broad assortment of bond types – including global and emerging markets, high yields, government and corporates. This allows our shareholders to take advantage of a range of opportunities.
If rates rise, the Flexible Income Fund has a variety of tools available that could benefit under various market scenarios – and we don’t have to decide in advance when rates will rise or how. Nor do we need to forecast whether there will be inflation and growth (which could benefit stocks), or whether there will be increased defaults and tighter money to attempt to combat inflation (which could prove difficult for stocks).
Bond prices have been stable lately, and one reason is investors’ massive demand for bonds. As a result, it’s been pretty easy to pick individual bonds that turned out to be good investments. But that may not be the case as bond markets change.
Given the potential for rising interest rates, we think it makes sense for bond investors to consider reducing the average maturity of the bonds they hold. We believe an even better solution for navigating changing bond markets is to incorporate the Flexible Income strategy that we use to manage FundX Flexible Income Fund (INCMX).
The Barclays U.S. Long Government/Credit Bond Index is composed of all bonds that are of investment grade with at least ten years until maturity.