Basic Fixed Income Portfolio Management For Market Timers

There’s been a lot of talk lately about a “bond bubble.”  And after the decade we’ve had, investors can perhaps be forgiven if they get a little frightened at the mention of the Big Bad “B” Word. So what’s the deal? Are bonds really about to crash and, if so, what can you do about it?

The short answer is “no.” High-quality bonds such as U.S. Treasuries, investment-grade corporate bonds, and the like will not crash. I believe use of the word “bubble” dramatically overstates the bear case for bonds but as usual, there is a kernel of truth to the bond-bear-market theory. To understand why, we must first understand how bond prices work in relation to interest rates.

Fixed Income Portfolio Management 101

Bond prices are sensitive to interest rates, that much is intuitive. What’s perhaps not quite so intuitive is how exactly bond prices react to changes in interest rates. Simply put, bond prices fall when interest rates rise and appreciate when interest rates fall. Confused? It makes sense after you think about it for a moment.

Say you’re in the market for a $1,000 bond. Current interest rates for whatever maturity bond you want to buy are 5%, meaning you expect to earn $50 per year for every $1,000 bond you buy.  Thinking that represents a pretty good deal, you buy a bond at 5% interest.

Skip several years into the future. Your yacht needs several expensive repairs and you need to sell your bond to help foot the bill. In the intervening years, however, prevailing interest rates have changed. To keep the math simple, let’s assume rates have fallen exactly by half, or 2.5%. Let’s also ignore all the technical considerations such as duration, etc. Lucky you! Since investors are now only demanding $25 per year for every $1,000 invested, you can sell your 5% bond for $2,000, or twice as much as you bought it for ($2,000 x 2.5% = $50 per year). Aren’t bonds great?

But suppose interest rates when the other way. Suppose they doubled from 5% to 10% instead. Now, you’d only be able to sell your 5% bond for half of what you paid for it, or $500. This is because nobody would pay $1,000 for your 5% bond when they could get a 10% bond for the same price.

Rates Have Nowhere To Go But Up

This interest rate dynamic is a large part of what has current fixed income portfolio managers worried. Sure there are quality concerns across the board, but the real dig is that interest rates are so incredibly low right now, most investors think they can’t possibly avoid going up in the near future. And they’re probably right. Remember when your money market fund was earning 4% just a few short years ago? There’s a pretty good chance rates will be much closer to 4% than the near-0% they currently pay. And that’s bad news for bond prices.

What’s A Nervous Fixed Income Portfolio Manager To Do?

I do not advocate market timing, not even the bond market. In that respect, fixed income investing is really no different than investing in the stock market. Tis far better to set an intelligent fixed income portfolio and stay the course than try to out-guess the market. Still, the interest rate situation can’t be ignored. Here’s what you can do to mitigate the risk of rising interest rates.

1. Keep Maturities Short - Bonds that mature in the near future are dramatically less sensitive to interest-rate risk than longer-term bonds. The single best measure of a bond portfolio’s interest-rate sensitivity is effective duration (available for most bond mutual funds on Morningstar.com). An effective duration of 5 years, for example, means the value of the bonds in that portfolio will fall 5% for every 1% rise in interest rates (and vice versa). Likewise, an effective duration of 7 years means prices will fall (or rise) 7% for every 1% change in interest rates. Most short-term bond funds sport effective durations in the 1.5-3 year range, which is where you want to be while rates are on the way up.
2. Keep Quality High – While nobody expects wide-spread bond defaults, economic turmoil is always particularly hard on marginal companies. Stay away from high-yield junk bonds, as their risk of default skyrockets if rates go up too fast since they won’t be able to roll over their debt at an affordable rate. Think Treasury Notes and only the highest-quality corporate bonds.
3. Cash Is King – Cash investments such as money market funds and high-yield savings accounts are ideal investments when rates shoot up since your principle is protected from interest rate risk and the rate you earn on your savings will tend to rapidly reflect the new, higher prevailing rates.