Bonds have been a pretty reliable source of gains for years now, but there’s uncertainty in the bond market now that interest rates are on the rise.
Changing interest rates are at the top of investors’ minds, and the markets may respond to rising rates in different ways.
It’s important to consider some of the possible outcomes we might face and think through how to best respond to these changes.
3 ways rising rates could affect bond markets
(& what it might mean for your portfolio)
1. Interest rates increase & the economy strengthens
The strong economy prompted the Federal Reserve to increase rates several times in 2017, yet continued growth and low inflation expectations helped both stocks and bonds. If this continues, total-return funds, which typically own stocks and bonds, could do well. This environment also could favor floating-rate funds and high yields because the additional yield may help offset a decrease in bond prices.
2. Rising rates trigger an economic slowdown
If rates rise and the economy slows, the areas of the bond market that have done well lately, like higher-yielding bonds, could come under pressure. This could spark a flight to quality, which would favor higher-quality corporate bonds, government-backed mortgage bonds or even Treasuries.
3. Interest rates rise & defaults increase
As rates rise, some leveraged companies may not be able to make their payments or refinance at higher interest rates, and they could default on their loans. Defaults have been very low in recent years, but if that changed, it could hurt lower-quality bonds like high yields. Higher-quality bonds, especially short-term bonds, could be better bet in this environment.
These three scenarios assume that rates will keep rising, but there’s also the chance that rates could stay the same. This would benefit most bonds, particularly those with higher yields.
What you can do now?
It’s tough to prepare for bond market changes in advance because, as you can see, what works in one market environment doesn’t necessarily work in another. If you sell out of high-yield bonds now because you’re worried about defaults, you could miss out on potential gains if the economic growth improves or if rates stay the same.
Even when market predictions are correct, the timing and outcomes of those predictions is often way off. Rather than trying to predict future markets, we believe it’s best to rely on a proven strategy that can help you respond to changing markets in a disciplined way and avoid making emotional mistakes.
As the old saying goes, the time to have a map is before you go into the woods. Bond investors aren’t in the woods yet, and that’s why this could be a good time to get your plans together. If markets take an unexpected turn, you’ll want to be able to stay on track.
A Plan for Changing Bond Markets
Our Flexible Income approach has helped thousands of investors navigate changing markets for many years now. This strategy was initially only available to our money management clients, but in 2002, we began implementing it for investors in our Flexible Income Fund (INCMX).
Here’s why we believe it’s up to the challenge:
Opportunistic - We can (and have) capitalized on a wide range of opportunities in the bond market, including in higher and lower quality bonds, strategic and high-yield bonds, floating-rate securities and even total-return funds, which aren’t fully invested in bonds.
Diversified - We build diversified bond fund portfolios and avoid getting too concentrated in certain kinds of bonds. Our Flexible Income Fund (INCMX) owns 10-15 different bond funds, which represent around 13,000 individual bonds.
Active - Our active approach has a good track record of adapting to changing markets. We owned short-term bond funds in more challenging bond market environments, like 2008. We moved into strategic, floating-rate and highyield bond funds when these funds came into favor.
How to Invest
The Flexible Income Fund (INCMX) is available at most major brokers, including Charles Schwab and Fidelity. You can also invest directly. Call 1-866-455-3863 or click here to open an account online.
Disclosure: Diversification does not assure a profit or protect against loss in a declining market.
Publication Date: Upgrader Quarterly: Winter 2018