Now that the Federal Reserve has raised interest rates, retirement investors are in a quandary. In the short term, rising rates are causing the values of outstanding bonds to fall—the typical core bond fund has given up 0.8% over this past week. Further losses may be in store, since the Fed has projected three more rate hikes for 2017.
But for income investors, there’s a silver lining to rate increases. After years of sagging yields, bonds have begun to deliver higher payouts. The 10-year Treasury is yielding 2.6%, which is a big jump from its 1.5% yield in June.
“For long-term investors, if you reinvest at higher rates over time, the yields can more than make up for capital losses at the front end,” says Roger Aliaga Diaz, Americas chief economist at Vanguard.
If rates spike up one percentage point, an investor in a typical short-term bond fund is likely to recover losses in 1.2 years, a recent Vanguard analysis found. From that point on, he or she would be earning more than before rates rose. With an intermediate-term bond fund, it would take almost two years to recover from the price hit of a sudden one-point rise in rates and be better off going forward.
Of course, there’s no way to accurately predict whether rates will keep heading up. So the recent hike shouldn’t prompt you to overhaul your portfolio. Still, it does makes sense to review your fixed-income holdings to make sure your bond-fund allocation is still suited to your risk tolerance and financial goals. These three moves can get you started.
1. If you’re seeking safety, stick with short- and intermediate-term bonds.
Given the years of low rates, many investors may have been tempted to hold long-term bonds, which pay higher yields than shorter term issues. But the downside is that longer bonds fall more in price when rates rise. “As rates rise, many investors are likely to discover that they are taking too much risk in their funds,” says Jennifer Ellison, a financial adviser at BOS in San Francisco.
In general, risk-averse investors would do best to stay with short- or intermediate-term bond funds that don't fall as sharply when rates move up. (For recommendations, go to our Money 50 list of recommended funds and ETFs.)
To find out how sensitive your particular bond fund is to interest rates, check a metric called duration. (You can find this number by looking up your fund at Morningstar.com.) A fund with a duration of five years, for example, is likely to rise or fall in price about 5% if rates move one percentage point.
2. Focus on high-quality issues.
You’ll find the highest yields offered by lower-quality debt—the typical junk-bond recently sported a 5.3% payout vs. 2.4% for an intermediate-term bond fund. But those hefty yields mean taking on far more risk of the issuer being unable to meet its obligations to pay interest or repay principal. Because of that credit risk, below-investment-grade bonds often trade more like stocks than bonds.
In 2008, when the S&P 500 fell 37%, the typical high-yield bond fund gave up 26.5%, according to Morningstar. By contrast, that year the average intermediate-term bond fund lost a more limited 4.7%.
Rather than making a big bet on junk bonds, a better strategy is to opt for investment-grade bond funds, which hold a mix of high-quality corporate debt and government issues. With yields close to 3% or so, these funds give you a bit more income than lower-yielding government-only bond funds, without sacrificing too much in safety.
3. Look beyond bond funds.
If you have a 401(k) plan, you may have access to a stable-value fund. This is typically a portfolio of high-quality bonds and cash that is "wrapped" in an insurance contract that guarantees your principal, providing protection against price drops. So you essentially get the stability of money market funds but yields that are closer to short-term bond funds.
For the year through November, stable-value funds delivered an average return of 1.6%, according to Hueler Analytics; over the past five years, stable-value funds returned an average 1.9% annually. By contrast, the typical short-term bond fund chalked up a 1.9% return year to date and a 1.5% average annual gain over five years. That makes stable-value funds ideal for the short-term portion of your bond portfolios.
Risk-shy income investors may also want to consider CDs. You can find one-year CD rates as high as 1.3%, according to Bankrate.com. And if you lock up your money for five years, you can earn up to 2.1% a year. Of course, rising rates may eventually zoom past those payouts, but you could ladder your CDs, which would enable you to keep reinvesting your money at higher rates. This strategy means buying CDs of varying maturities, perhaps one year, two years and so on. As each CD matures, you can roll it over into another one at the current rate. That way you can capture rising rates—with no worries about short-term losses along the way.