Is it time for your portfolio to break free from the earthly bonds?

Feb 7th, 2021: Hindsight is 2020, but the FED acted with equally great foresight in 2020 and rescued the financial markets from a once in a century catastrophe. Come 2021, the clarity of that FED vision is starting to blur a bit. With the money supply that FED has flooded into the financial markets along with the stimulus checks by the government, we now have a frothy financial markets that almost disregards any fundamentals based valuation. Retail investors are happy to take the price and buy more stocks.

With the asset prices inflating, the long term interest rates that just skirted close to 0 are now starting to rise. This rise in yield is being stoked by an increase in inflation expectation by the financial market participants. If this continues, this will be a reversal in trend that has been in play for the last 40 years! Most of us saving for our retirement have been doing so under the backdrop of falling interest rates since the early 1980s. This is all we know. Now, we are waking up to a new reality.

Traditionally, a portfolio of 60% stocks and 40% bonds was considered ideal for someone closing in on their retirement. The bonds would produce sufficient income to supplement the retirement expenses. Today, those bonds are hardly producing any income as the yields are close to zero. To add fuel to the fire, an increase in yield will lower the value of the bonds in a portfolio and an investor will incur losses! Treasury bonds that are regarded as risk free assets producing reasonable returns have now become return free assets with potential for no upside and only downside risks!

Investors and advisors alike are scrambling to find alternatives to address this situation and rescue their portfolios for long term survival. Below we look at some alternatives to the traditional bond investment strategy.

To start off, we need to understand a bit about the two different types of risks that are at play.

Inflation Risk

As we talked in a previous blog on Charming the Inflation Snake, this is the risk that inflation picks up earnestly. When inflation picks up, all goods and services become more expensive, wages need to rise. The cash you may have sitting in your bank account fetches less and less goods and services as time passes. The FED is in support of inflation today. They would like it to rise moderately, but not beyond a limit. Their current policies are aiding a rise in inflation. For asset gatherers and savers, this is not a great thing.

Interest Rate Risk

When the interest rate moves, it changes the value of the bonds you own. An easy way to see this is what all homeowners have witnessed in the last few decades. Over the years, interest rate has been falling steadily. Every time the interest rate falls, homeowners would rush to refinance their mortgages so they can get a better rate and thereby pay lower interest rate. Were they not able to refinance, their mortgages will be worth more for the banks as those mortgages are still paying higher interest rates. Thus, as the interest rate falls, bond value actually rises and vice versa. If the interest rate start rising over the next couple of decades, the bonds that you own today will continually lose value. This is the risk with interest rate.

How do we address these risks?

For inflation risk, we can hedge the loss of purchasing power by owning assets that go up in value as the inflation picks up. To name a few such assets are stocks, real estate, commodities and certain kind of bonds. Yes, bonds - they are called Treasury Inflation protected bonds or TIPs. The income they produce are tied to the inflation rate and hence will go higher as the inflation rate increases.

For interest rate risk, we can hedge the loss in value of a bond by owning assets that are not impacted by interest rate changes or are impacted favorably by increase in interest rates. One good example is bank stocks. Banks make money when long term interest rates are rising compared to short term rates. Thus, if the interest rate curve steepens, banks are in a good place to earn more and hence it would make sense to own bank stocks.

Another asset to look at are value stocks as opposed to growth stocks. When growth was scarce, interest rate was low and everyone wanted to own a stock that provided growth. However, as growth picks up broadly and the economy itself starts growing rapidly, all stocks start growing. This favors value stocks as their value normalizes to the upside.

Some investors and advisers have taken shelter in stocks that pay high dividends. When you divest your bonds that used to provide income, dividend paying stocks become a great choice as that income from bonds can be substituted by the income from dividends.

All the above strategies to hedge interest rate risk require an investor to sell off their bonds and be exposed to additional equity risk. Are there strategies that can still own bonds and yet are able to mitigate interest rate risk?

Sure, there are. Perhaps these are some strategies that a long-term investor should give some serious attention to. One of them is bond laddering. In a bond ladder, an investor holds bonds of varying maturity. So, for example, if you have $100,000 invested in bonds, you may allocate the first $25,000 in bonds that mature in year1, the next $25,000 in bonds that mature in 2 years and so on. The idea is to hold the bonds until they mature. When you do this, you are not subject to the impact on the price of the bond due to changing interest rate. As one rung of the bond matures, you take that proceeds and invest into the next higher rung. When you do this, you are locking into a higher interest rate thereby improving your income.

If you are still in doubt whether the interest rate is in a secular uptrend from here on, you may not be ready to make drastic changes to your portfolio just yet. One way you can think of mitigating a potential rise in interest rate would be to lower the duration (maturity period) of your bond portfolio. As the duration of your bonds reduce, so does the impact of interest rates on the price of the bonds. This may be just sufficient to help you sleep through the night for the time being.

The strategies outlined here are by no means exhaustive. Based on your personal situation, you may have access to many more strategies or some of the above strategies may not work out for you. Consult your wealth manager or talk with us.