Photo by Amy McTigue
Interest rates have risen over the past few weeks, and as a result, there are no shortage of headlines predicting an end to the “Bond Bubble” or another “Taper Tantrum”. A bond market selloff in response to tightening credit was nicknamed the “Taper Tantrum” back in 2013 when the Fed Chairman, Ben Bernanke, announced that the Federal Reserve would begin tapering off the $70 billion or so of bond purchases it was making each month.
A quick Google search yielded these articles just from today.
U.S. Morning Links: Alan Greenspan Warns of Another ‘Taper Tantrum’ – Wall Street Journal
The popping of this bubble poses a ‘huge risk’ – CNBC
Is the bond bubble about to burst? – Economic Times
If the bond bubble bursts, you’ll need to be prepared – MoneyWeek
Are rates about to rise? Maybe.
Should we panic and sell all of the bonds and interest rate sensitive investments in our portfolios? Absolutely not.
Had you done so in 2013 during Taper Tantrum I, you potentially would have missed out on strong performances in 2014 as indicated by a 5.97% return from the Barclays US Aggregate Bond Index, or even a 27.29% return from the interest rate sensitive Dow Jones Composite REIT Index.[i],[ii]
So what can we do? I suggest we draw from advice offered to parents when dealing with a tantrum prone child.
Ignore the behavior. Just as you don’t want to encourage a child to act out for attention, remember that the headlines are meant to draw you in so that more ads can be sold. If you have a solid plan in place, such as a disciplined allocation plan and/or a bond ladder, you are well prepared for whatever happens. It is what actually happens, such as a bond maturing instead of trying to guess what will happen, that should determine your next move.
Acknowledge the feeling. Fear and greed are the two primal emotional states that drive markets. It’s normal to feel some level of anxiety or euphoria when our investments perform one way or another. However, if fear of normal and even expected events such as market volatility is keeping you up at night, you should revisit your overall strategy and investment plan.
Anticipating volatility and allocating in such a way as to minimize the inevitable ups and downs is much more manageable than trying to predict what the next market zig or zag may be and trying to beat the crowd.
Teach other ways to handle emotions. As a parent, I frequently remind my children that feeling emotions is normal but dealing with them in a productive way is what makes us human. (Well, that and opposable thumbs.)
These are a few of the ways we can minimize our emotions when managing fixed income:
· Evidence-Based Investing – The price of a bond can tell us whether it is an appropriate holding in a portfolio. Academic research has shown two primary factors determine fixed income prices, the term of the bond and the underlying creditworthiness of the issuer. If a highly rated bond is trading for a lower price than other similarly rated offerings, the market is telling us that there is probably something we don’t know, so steer clear. Free lunches are rarely cheap.
· Bond Ladders – Owning individual bonds can provide predictability. Knowing when interest payments and maturities are going to occur not only can provide peace of mind, it allows for systematic reinvestment into longer term bonds that typically pay higher yields.
· Premium Bonds – One type of bond we seek when building ladders are those priced at a premium. Say we have a choice between two 10 year bonds, one selling at par ($1000) with a 2.65% coupon or another going for a premium ($1,205) with a 5.00% coupon. Both bonds yield 2.65% to maturity, but one may be better suited than the other if rising rates are a concern.
We would likely choose the more expensive bond even though it will only mature at $1,000 because it will pay us $50 every year until maturity versus $26.50 for the par bond. Those accelerated cash flows should be thought of as principal being returned early and that can be reinvested sooner, which would be a benefit if rates are rising.
A variant on premium bonds are known as “Kickers” or “Cushion Bonds”, which are callable premium bonds. We assume that these will be redeemed on a call date before the stated maturity date and put them in a ladder based on the call date. However, if rates rise, in some cases the bond may not be called and the yield you receive will increase, or “Kick”. Because there is some uncertainty as to when, or if, the call may happen these bonds typically reward an investor with higher yields than bonds of similar maturity.
None of these approaches can completely avoid volatility. Sometimes a child is going to throw a fit, in spite of our best efforts. With preparation, we at least make the storm a little more tolerable.
[i] Indices are un-managed and you cannot invest directly in an index.
[ii] The Barclays US Aggregate Bond Index and the Dow Jones Composite REIT Index are un-managed groups of securities considered to be representative of the bond and REIT markets in general. They are market value weighted indices with each bond or REIT's weight in the respective index proportionate to its market value.