Lifeboat Drill for Bond Investors
Overall, the stock market had a pretty good week last week. The S&P500 made another new intra-day trading high Friday and closed the week up 1.40% from the week before. (1) It would have been higher – except that it had dropped 0.60% on Wednesday. (2) That was the day Fed Chair Janet Yellen suggested that the Fed might be raising interest rates sooner than the market had expected.
Why do the drill now?
Anyone who has gone to sea – whether luxuriating on a cruise or on board one of the Navy’s BGBs (big grey boats) – knows that, very soon after putting to sea, you’ll be participating in such a drill. This is so, if things go all wrong, you’ll know what to do to save yourself.
I thought it appropriate to bring this up now regarding potential challenges ahead for bonds and similar issues. Knowing what’s coming and what to do before the event takes place can help minimize panicked responses that could sink your portfolio..
What did Janet do?
Not much, really. I thought her talk was pretty clear. The catalyst for the selloff came when she said that the Fed wouldn’t raise short-term interest rates until an extended period of time after the end of quantitative easing. Seemed pretty tame to me. Well, I’m not in NY nor do I trade bonds.
Those folks, and their brethren all around the world, did some quick trader math and decided that this meant that rates could be rising a whole three months earlier than they thought 2 minutes before she talked. Well, deduced said traders, that’s infinitely long in trader time, so I’d better sell before everything goes lower.
Cooler heads prevailed on Thursday – none of this is happening until sometime next year, after all – and both bond and stock prices recovered through the rest of the week.
Where’s the risk?
Markets change direction based on perceptions regarding expectations. That’s a reason why you see moves based on either “better than” or “worse than” expected news or events. Last week, the traders hadn’t expected seeing such hard evidence that interest rates will be rising so soon. So, they sold.
My worst-case concern is this.
Whenever the Fed actually makes the official announcement that it will, in fact, be raising short-term rates, there may very likely be all kinds of near-term ugly in the markets. There’s probably going to be lots of calls to abandon your market ship/portfolio. As with any stressful situation, those who keep their heads will have the chance to survive – fiscally, in this case.
The stories du jour will likely be variations of how we “can’t possibly” grow and expand now that the flood of money is going away. Even though this will be a well-known and anticipated event, the markets likely are going to sell off. There will be all kinds of wailing and moaning going on.
I truly hope this doesn’t happen; that the markets will instead be able to ease into the new reality with interest rates driven by market forces once again. More important, I hope many investors don’t get caught up in it all. However, based on prior experiences, logic is not always present in the markets, is it?
Suggestion
Given this increased focus on the timing of interest rate raises, this is likely to be an interesting year for bond investors.
Please understand that these thoughts are precautionary only and not to imply that you need to set up camp in your lifeboat – just know where it is and how to work it.
None of this information is intended to suggest that your bonds will not continue to pay their interest. These comments have to do with what could happen to your bond prices; whether individually or in funds of whatever bond type. Remember, rates going up equal prices moving lower.
Bloomberg folks say that, looking ahead, the bond market currently is pricing in a further increase of 60 basis points in 10-yr Treasury yields over the next two years. (That’s just 6/10ths of 1% but is about a 20% increase.) Short-term rates, currently near zero (0.05% for 3-mo T-bills) are expected to jump to 3.3% in five years. That’s a huge jump.
Near-term dangers for bond investors seem minimal. With prices up and investing seas calm, this may be a good time to consider some re-allocation of some of your fixed income assets into senior bank loans and high quality international bonds. And be sure to be aware of the duration (interest rate risk) of your bond holdings and to keep the maturities of the bonds at 7 to 10 years, max.
Forewarned is forearmed, I’ve heard. I think by doing this action you can help smooth the waters and not be worrying whether you should start taking meals in that lifeboat…just in case.
Cheers!
Mike
509-747-3323
(1) CNBC, 21 Mar 2014
(2) Ibid.
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Past performance is not indicative of future returns. Investing in securities of any type involves certain risks, including potential loss of principal. Investment return and principal value in a bond and/or securities portfolio will fluctuate so that investments, when sold or redeemed, may be worth more, or less, than the original investment. Investing in sectors may involve a greater degree of risk than investments with broader diversification. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.
