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Bond strategies for today's markets

The right reaction to rates depends on your goals. Here are five strategies to consider.

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Conditions in the bond market have been unprecedented in many ways during recent years—above-average performance, rates near all-time lows, and, more recently, one of the fastest rate jumps in many years. With so much of the bond market being outside the limits of an investor’s experience, big questions have come up: Can bonds provide value to investors given the limited upside for price increases and the likelihood of rising rates in the future, and what role can they play in your portfolio now?

“Today’s rates are unusually low, and it does seem likely that, over time, rates will move higher,” says Julian Potenza, a macro and asset allocation analyst on Fidelity’s fixed income team. “Many investors think we will return to ‘normal’ rates soon, but there are some good fundamental reasons for today’s low rates, including slow economic growth, low inflation, and an aging population. There is no reason rates can’t stay relatively low, and in the event of a recession or global crisis, it is possible that market rates will actually fall—an outcome the market may be underappreciating currently.”

Regardless of what happens to rates, Fidelity’s bond team still believes that bonds can provide meaningful diversification, deliver income with lower long-term volatility than some other options, and help investors prepare for their goals. The key for most investors is to remember why they own bonds at all. Many investors have a strategic plan that includes an allocation to bonds. It may be worth remembering that if you own bonds for strategic reasons, it may not make sense to make a tactical move out of bonds because you are worried about the current market dynamic—even if it is tempting to do so. Predicting future interest rates has proved challenging. We think a better strategy is to adopt a balanced investment allocation you can live with through many different market conditions.

Thinking about your investment timeline

“No one likes to see the value of a fund or the price of his or her bond fall,” says George Fischer, managing director of research, macroeconomic and structured. “But bond investors need to remember that price is just one part of total return. Making tactical moves to reduce bond market exposure or lessen the impact of rate changes on your investment may make sense if you can’t afford short-term losses, but if you are investing strategically and have a longer time horizon, it probably doesn’t make sense.”

That’s because rising interest rates hurt bond prices in the short term—bond funds see their net asset value fall and individual bonds tend to suffer price declines in the secondary market. However, over a longer period, rising rates may actually benefit bond investors. Funds may be able to produce more income over time, and individual bond investors may be able to buy securities that offer higher yields down the road.

So how can you tell if the benefits of rising income will outweigh the short-term price losses? A strategy called “immunization” may be able to help you ensure that the benefits of potential rate increases outweigh the downside. Immunization aligns your investments with your timeline using a measure called duration. Duration estimates the impact interest-rate changes may have on bond prices, and by choosing a bond portfolio with a duration less than the amount of time you plan to be invested, your increased income from a rate change should outweigh the price losses due to rate increases.

Look at a simplified example below. Let’s say you expect to invest for seven years, but choose a bond fund with a duration of five years—though the same principle would apply if you bought a bond each year with the same duration, and sold it at the end of the year. If rates do rise, the income benefits should more than offset the price after five years. And in this example, the portfolio performs better in a rising rate environment than a falling rate environment after seven years. This example is simplified to illustrate the relationship between price and income when rates go up, and it is important to note that it doesn’t take into account issues like transactions, liquidity, changes in bond prices due to how the market perceives the risk of the issuer, or market events. All these things could affect the total return of a bond investment.

1. Goal: Generate income now

Investors looking for income have faced serious challenges: As of September 30, 2013, most types of bonds still paid yields in the bottom 20% of historic levels—despite the recent increases. To beat inflation or achieve income goals many investors have turned to higher-yielding options, namely longer-maturity bonds or lower-quality bonds. These investments can offer an increased income stream. Of course, the added income comes with additional risk.

The recent rate increases highlighted the risk that prices will fall as rates go up, and longer-maturity bonds are more sensitive to rate changes. In volatile markets, liquidity risk and credit risk can be important factors as well. So if you are investing for current income, you need to balance the level of income you can achieve with the amount of risk you can tolerate—based on how long you can invest, the likelihood you will need to access the money, your emotional risk tolerance, and other factors.

2. Goal: Investing for the short-term

For investors who need their money in the near future—say retirees counting on their principal for living expenses or parents saving for college expenses next year—the prospect of losses may be unacceptable. In that case, one answer to rising rates is to look at short-duration bond funds or short-term CDs. These options may not offer the high yields of longer-duration fund or high yield bonds or funds. But, historically, they have had less price sensitivity to rate changes, and they typically offer a competitive yield relative to money market funds. In a rising interest-rate environment, short duration options may outperform longer-duration funds, in spite of lower current income.

3. Goal: Long-term investment and diversification

One of the basic tenets of building a portfolio is that investors with large exposure to the stock market should be looking for diversification by investing in longer-duration, high-quality bond funds, including Treasury bonds and certain municipal bonds. These funds may perform well when interest rates are falling, often in response to a disappointing economic environment or other market risks that will hurt stocks. The theory that bond returns can help offset stock losses has been proven time and again (see chart below). The question facing investors now is, could this time be different?

Some market observers believe that the Fed’s economic stimulus measures have been driving bond prices higher with lower rates and supporting higher stock prices by making the cost of capital lower for corporations and driving more share repurchases and dividend payouts. Because of the Fed’s unprecedented involvement, the normal dynamics of stocks and bonds may be out of whack, and some people believe both stocks and bonds could fall as the Fed withdraws support. An additional concern is that investors will make a mass exodus from the bond market, causing prices to crash—though we do not subscribe to that theory.

Even this year, stocks and bonds have maintained their traditional relationships. Stock returns have far outpaced bonds, but when concerns about military involvement in Syria surfaced in the fall of 2013, bonds rallied as stocks stumbled.

“No one knows for sure if the traditional relationship between stocks and bonds will hold during this cycle,” says Potenza. “But we think there are good reasons for bond interest rates to stay relatively low, including the Fed’s clear intention to remain accommodative for the foreseeable future, the slow pace of global economic recovery, and demographic changes driving demand for income products. The process will likely be punctuated with bursts of volatility, but a gradual rise is our base-case scenario.”

4. Goal: Investing for a goal with a specific timeline

Defined-maturity funds and individual bonds offer investors the ability to invest over a specific time horizon—for example, to fund college or retirement expenses in a specific year. This investment strategy is meant to balance interest-rate and reinvestment risk, and to reduce volatility and interest-rate exposure if the bond or fund is held to its target maturity. In addition, investing in individual municipal bonds or municipal bond defined-maturity funds can offer tax advantages.

So for instance, let’s say you are investing for your child’s college education, which will start in six years. You want to make sure that interest-rate changes don’t threaten your investment, but are looking to earn some return on your money to help pay the bills. You could invest in a defined-maturity fund or in individual bonds with a maturity date of 2019 and hold your investment to maturity. Price volatility will decline as you approach 2019, and, no matter what happens to rates, you should get your principal back at maturity (assuming there are no defaults).

5. Goal: A balance of income, diversification, and volatility

Many bond investors seek a balanced mix of the factors listed above: income generation, principal stability, and diversification. A broadly diversified bond portfolio that includes exposure to a variety of credit qualities and maturities may suit such purposes well. Broadly diversified funds have the ability to invest in a wide variety of sectors, providing flexibility to seek attractive combinations of risk and return. Relative to a long-duration government bond fund, a broad bond market fund may provide slightly less portfolio diversification benefit, but generate higher current income and greater resilience to rising interest rates. A good example is the Fidelity Total Bond fund, illustrated below.

What it all means

The bottom line: There is no one-size-fits-all strategy for fixed income investors. Consider first what your individual goals, risk tolerance, and timeline are. Then use the guidelines above to come up with a strategy that works for you.

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In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible. Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
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