It’s difficult to pin the stock market’s volatility on just one catalyst, but the Federal Reserve and its changing monetary policies certainly play a big role.
Not that the Fed is making waves. The Federal Open Market Committee meeting this week once again validated the expected, gradual pace of interest rate increases. The latest bump to 1.75% from 1.5% marks the sixth 0.25% increase in roughly 2 1/2 years, and investors should expect two more hikes in 2018 based on consistent commentary from the central bank.
What may be worrying investors now is that the Fed got a bit more aggressive in its outlook for rate hikes in 2019 and 2020. And given that the U.S. economy and stock market have functioned on rock-bottom interest rates for so long, some trepidation is natural.
This does not mean that the stock market is about to implode, or that the U.S. is doomed for a recession as borrowing costs skyrocket. Fundamentally, rates are rising because the U.S. economy is at full employment and consumers are confident — thus eliminating much of the need for loose, stimulative policy we saw during the depths of the 2008-09 financial crisis.
It does mean that the rules of investing in a near-zero interest rate environment are going to change. And based on some of the volatility we’ve seen in the last few months, there are signs those changes are already underway in many corners of the market.
If you’re worried about rising rates and a more challenging environment on Wall Street, here are five tips to protect yourself from the Fed as it looks to normalize monetary policy and the rules change for investors as a result.
1. Don’t rely on plain-vanilla long-term bond funds
The fact that bond principal declines as rates rise is obviously a big problem for long-term bond funds during a period of rising rates. Just consider that in the last three months, the government-focused iShares 20+ Year Treasury Bond ETF (TLT) has lost about 7% and the Vanguard Long-Term Bond ETF (BLV) that is a mix of Treasurys and corporate bonds has lost about 6%. These funds have an average duration of 17 and 15 years, respectively.
As these funds continue to rotate out of older less-attractive bonds with weaker yields, it’s realistic to expect principal in these funds to decline more — perhaps significantly so — than the yield they provide.
2. Seek out unconstrained funds
An exception to this rule is the wise manager of an active bond fund who has been able to find myriad opportunities rather than be tied to long-term bonds in a difficult environment.
It’s important to look closely at a fund’s prospectus to make sure it is truly “unconstrained” in both investment style and scope. A truly unconstrained ETF worth considering is Virtus Newfleet Multi-Sector Bond ETF (NFLT), which has delivered basically flat returns in the past three months despite a rough bond market. That’s no mean feat.
If you aren’t tied to exchange-traded products and favor a conventional mutual fund, consider Calvert Absolute Return Bond Fund (CUBAX), which is up slightly in the past three months and has outperformed its aggregate bond benchmark significantly over the past three years of central bank tightening.
3. Consider short-duration bond funds
Of course, one way to mitigate the rising rate environment is to rely on a good tactical bond fund, but another way is to simply shorten your durations. The iShares 1-3 Year Treasury Bond ETF (SHY) has dropped only modestly in the past three months, even as longer-term government bonds have slumped, thanks to the short-term nature of its investments.
A turning point for bond yields
Of course, short-term bonds don’t pay you much. Currently iShares 1-3 Year Treasury Bond ETF’s 12-month trailing yield is just 1.1% and its current distribution yield has ticked up to just north of 1.3%. That’s a tough trade-off for an investor who wants to limit downside risk but still needs income.
4. Be wary of the junk-bond trap
Of course, many folks see the low yields on Treasurys across the board and decide to play in the universe of high-yield bonds instead. Admittedly, this strategy looks far preferable on paper. Consider that the iShares 0-5 Year High Yield Corporate Bond ETF (SHYG) has actually gained a tiny amount in share value even as it delivers a trailing 12-month yield of 5.5%. Attractive, right?
Well, the problem is that the junk-bond feeding frenzy of the last few years has been predicated on the notion that debt is cheap and the economy is booming. That’s made it easier for poorly run companies with bad balance sheets to pay their junk-bond interest, but it’s an open question as to whether that trend will continue.
It may not take a significant rise in default rates to create big pain for junk-bond investors, so keep in mind that these are not “safe haven” investments like Treasurys and come with significant risks. After all, they are called “junk” for a reason.
5. Be wary of ‘bond-like stocks’
Beyond junk bonds, it’s also worth noting that there has been equally eager demand for high-yield dividend stocks over the last few years. The reasons are similar — why settle for a measly 2% to 3% in a bond fund when you can get next to double that in REITs and MLPs, with the chance of some big appreciation in this bull market to boot?
Yet as the market gets choppy, the risks of stocks vs. bonds is becoming more apparent. As rates rise and you can regularly find a 4% yield in investment-grade corporate bonds with 10-year durations or less, then dividend stocks become less attractive.
For proof, look at Real Estate Select Sector SPDR Fund (XLRE). This fund is down about 8% in the past three months as the Fed has come more into focus. With the higher risk profile of an equity investment and a yield of just 3.4%, the limitations of this fund are painfully clear.
As the Federal Reserve tightens monetary policy, the pain will only continue on investments like these.
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