See what has driven recent bond market returns. Read the article.
Find ideas on what to do now. Read the article.
See the pros and cons of short duration strategies. Read the article.
In 2015, bonds have generally provided positive performance, proving their resilience despite the end of the Fed’s bond buying program. But with last year's market volatility, flareups in the muni market and the Fed's debating when to raise rates, many bond investors remain concerned.
What does this changing market environment mean for you? The answer depends on why you own bonds—and how sensitive you are to possible price declines. But for most investors, bonds continue to play an important diversification role in their portfolio. Here are some of our recent insights on the bond market, the outlook for rates, and some strategies to consider, depending on your particular needs.
Low and volatile rates
- The Fed has ended its monthly bond purchases, and has begun to discuss the possibility of raising rates at some point in the future.
- After rising sharply on concerns about the reduction in stimulus in 2013, rates generally fell in 2014 and so far in 2015.
- There are some reasons to believe that the Fed itself will maintain low-rate policies—and that rates could stay relatively low by historical standards. These reasons include strong demand for income producing assets and the relative appeal of U.S. bonds to those of other nations.
- Regardless of the rate environment, specific issuers may experience volatility.
The long-term outlook
- The markets have experienced periods of volatility and that may be a sign of things to come.
- Investors should not expect bond funds to produce the double-digit returns seen in recent years.
- Predicting interest rate changes has proven difficult and is not a key part of Fidelity's investment process. Nevertheless, there are reasons to believe that rate increases will be uneven, rather than sharp and sustained. Any sharp and rapid increase in rates would likely slow economic growth and, consequently, attract some investors back to fixed income.
What it means for investors
- Generally, rising rates are bad for bonds. Bond funds see their net asset value fall in price, and individual bonds and bond exchange-traded funds (ETFs) also see price losses.
- However, rising rates could create opportunities as well. Over time, funds should generate more income, and individual bond investors might be able to buy securities that offer higher yields. And as prices go down, some bonds may become undervalued.
- Not all bond investments will be affected equally. In general, lower-yielding, longer-maturity and higher-quality bonds have higher durations, and that means more price sensitivity to rising rates. For higher-yielding, lower-quality bonds that are exposed to the issuer’s credit risk, the improving economy signaled by gradually rising rates may benefit the financial health of certain non-investment-grade issuers enough to dampen the effect of rising interest rates.
- We believe that bonds continue to serve an important function as part of an overall asset allocation strategy. Most investors should avoid the temptation to tactically trade in and out of the bond market. Rather than trying to time the market, we believe that a balanced approach to asset allocation is more likely to generate favorable long-term outcomes.
Strategies to consider
- For investors who intend to hold individual bonds to maturity, there may be no reason to change strategies due to rising rates.
- If your primary goal is income generation, remember that higher-yielding funds tend to have greater exposure to interest rate risk, credit risk, or liquidity risk. So chasing yield can be risky—be sure to consider your time horizon and risk tolerance before investing in high-yielding bond funds. Also, consider a diverse mix of bond and non-bond income sources, including real estate investment trusts (REITs) and dividend-yielding stocks.
- If your primary goal is to minimize price losses if rates rise, consider short-duration bond products. These funds offer a competitive yield relative to money market funds, though credit risk and interest rate risk are greater. At the same time, these funds may offer less price sensitivity to interest rate changes than longer-duration bond funds do. In a rising rate environment, short-duration funds may outperform longer-duration funds, in spite of lower current income.
- If you are looking mostly to offset stock market risk, consider longer-duration high-quality bond funds. These funds will have interest rate risk—and prices may decline more than other bond funds when rates rise. However, they may perform well in response to challenging economic conditions—when stocks may suffer.
- If your investment goal comes with a specific timeline—for instance saving for college—consider individual bonds or funds with a defined maturity. If you match the duration of your investments to your investment timeline and if you can keep your money invested until maturity, you may not have to worry about interest rate changes. A ladder of individual bonds or defined maturity bond funds may also help balance interest rate risk, reinvestment risk, and current income.
- If you are looking for a balanced mix of income generation, volatility, and diversification, consider a broadly diversified bond fund. By including a wide variety of bonds, these funds seek an attractive combinations of risk and return. They may offer less diversification benefits to offset your stock portfolio than a long-duration government bond fund does, but they may provide more current income and greater resilience to rising interest rates.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917