Why You Shouldn’t Sell Your Nose-Diving Bonds
Editor’s Note: In the past few weeks, we’ve watched stocks and bond yields soar on the heels of unprecedented political news. But as yields have risen, bond prices have fallen, rattling income investors. Rather than selling, Chief Investment Strategist Alexander Green says it’s time to tighten your grip on the bonds you own. In today’s article, which also ran in our sister publication Investment U, Alex outlines the three smart ways to tailor your bond investments to today’s rising interest rate environment. Check out Alex’s advice below, and share your thoughts by leaving a comment.
November was a momentous month for the markets.
The Dow climbed 11%, its biggest monthly gain since October 2011.
The Nasdaq and the S&P 500 also hit new all-time highs, as did the small cap Russell 2000. It had its best month since September 2010.
European stocks also finished the month higher, as did Japan’s Nikkei Stock Average. It rose 5% in November.
Why the sudden surge?
The surprise election of Donald Trump erased the prospect of four more years of partisan bickering and gridlock – and led investors to expect new pro-business policies including tax reform, deregulation and increased infrastructure spending.
Just as the polls, the pundits, the mainstream media, the futures market – and most newsletter editors – got the election outcome wrong, so did most big institutional investors. Many of them spent the month playing catch-up, shoveling billions into the market.
However, investors aren’t betting that just economic growth and corporate profits will be better. They are also betting that inflation and interest rates will be higher.
We know this because the dollar hit a 13-year high in November – and bond yields had their biggest one-month increase since 2009.
Let’s take a closer look at each, starting with bonds.
The yield on the 10-year Treasury note recently finished at 2.444%, a 17-month high. That’s up from 1.834% at the end of October. (The 10-year yield is now up a full percentage point higher than it was in July.)
Bond prices fall when yields rise, so these investments suffered through what I call an “inverted rally.”
The Commerce Department recently reported that GDP had its strongest growth in two years in the third quarter. Fed Chairwoman Janet Yellen confirmed that we’ll almost certainly see a quarter-point rise in the discount rate this month.
And if the economic recovery continues to pick up the pace, we will see still more rate hikes in 2017.
The dollar is firmer because higher rates make the greenback more attractive to yield seekers. Remember that international investors scour the world for competing interest rates the way individual investors compare CD yields at banks.
Mutual fund cash flow figures reveal that November’s market action caused investors to cash out of bonds and plow the money into stocks. That seems like a smart move to many. After all, the trend is your friend, right?
Not so fast.
Yes, you should own stocks, but note that they have gotten more expensive, not less. Valuations remain stretched by historical standards – the S&P 500 now sells for more than 20 times earnings – and at some point, this rally will run out of steam.
Moreover, you don’t ever want to eliminate your bond allocation. Bonds provide the ballast for your portfolio. So own them, but consider these three guidelines:
- Stay with maturities of five years or less. Longer-term bonds are far more volatile than short- to medium-term bonds. Not only will shorter-term bonds fluctuate less, but they will return your principal sooner to reinvest at higher rates.
- Know your bond duration. Duration is a measure of interest rate risk. For example, a bond with a one-year duration would lose only 1% of its value if rates rose 1%. A bond with a duration of 10 years would lose 10% if rates rose the same amount.
- Consider tax-frees. Right now, the national average yield on a 10-year A-rated muni is 2.4%. That’s higher than a 10-year Treasury – and the T-bond interest is fully taxable.
In sum, stocks are in a confirmed uptrend, and bonds have entered a bear market.
Yet the smart investor will still own both.