Don't Be Afraid of Heights

“Fear can get in the way of sound judgment.” This is a wise quote from Franklin Delano Roosevelt. The arguments for holding core bonds as part of a well-diversified portfolio are as strong as ever, and those who overreact to the prospect of rising interest rates may be doing themselves – and their investment portfolios – a disservice. Today’s bond investors could take note: With bond yields low and the Federal Reserve embarking on an interest rate hiking cycle, there are plenty of real concerns facing investors. But a reasoned analysis that takes into account historical interest rates, the likely path of rates going forward, and the impact that past interest rate hikes have had on returns, suggest that rising rates may not be a big a threat to bond investors as one would think.

There's no escaping the fact that rising rates undermine the value of many bond funds as well as long maturity individual bonds. The price drop is more severe for bonds with longer maturities, because owners will be stuck with below-market yields for a longer period of time. A bond maturing next month will lose virtually nothing if rates rise, because the investor expects to get his principal back soon, while one maturing in 30 years will be hammered down in price.

We have recommended steering clear of bonds with long maturities for quite some time now. In our opinion, it’s been a while since it has made sense to invest in bonds with long maturities. You’ve picked up substantially more volatility with very little reward in most cases over the past several years. The duration of our bond portfolios are, and have been, managed to prepare just for the scenario we see playing out over the next several years. As bonds are called or matured during a rising rate environment, we will have the ability to reinvest into higher returning bonds. For the right reasons, mainly a more robust economy, we will welcome higher interest rates.

See below for income sector returns and reactions to a rising rate environment.

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