By Dan Trumbower, CFP
After rallying for four decades straight, bond markets are experiencing their worst year in history. That's thanks to interest rates, which have also reversed a long-term trend and have risen sharply. The inverse relationship between bond prices and interest rates has come to the forefront for investors looking for fixed-income solutions.
Lower bond prices have also confounded stock investors who, historically, have included bonds in their investment portfolio to provide a ballast against falling stock prices. Typically, bonds have had a negative correlation to stocks, performing well when stock prices decline and vice versa. For the first time in decades, stock and bond prices are falling in sync, compounding the stock market's poor performance. Though a positive correlation between stocks and bonds is not expected to last, it is currently wreaking havoc on investment returns.
If that were not enough to increase despair among investors, the yield curve, which charts the relationship between yields on long-term government bonds with short-term government bonds, has been flattening all year and recently inverted. That means long-term bonds are yielding less than shorter-term bonds, a strong indication of a slowing economy and possible recession.
Not All is Lost for Fixed Income Investors
Unquestionably, the current market environment has been extremely sour for fixed-income investors and equity investors looking for bonds to counterbalance declining stock prices. While a bond market environment like the current one presents unique challenges, investors can still reap the benefits of a bond market in transition. It just takes careful planning and an understanding of the options available.
Here are a few ways investors can still benefit from rising interest rates:
Higher Long-Term Bond Yields
The spike in interest rates has lifted the yield on the 10-year U.S. Treasury Note to its highest level since 2008. As of October 2022, the 10-year yield topped 4%, nearly double from just a year ago. While yields are expected to increase further due to additional and telegraphed Fed rate hikes, even at current levels, bond investments are producing much stronger income levels than we have seen in many years.
The more attractive opportunity may be with corporate bonds, which have been beaten down this year. In other words, they are deeply discounted. The Bloomberg Aggregate Bond Index is down more than 16% YTD, with the average yield on the lowest tier of investment-grade bonds hitting 5.75% in September.
With corporate bonds, quality and duration matter. Companies with investment-grade ratings of "A" to "AAA" are considered low credit risks. They also tend to perform better in volatile markets. If you structure your bond portfolio to coordinate with your investment time horizon and liquidity needs, you don’t need to be concerned so much with short-term price movements which are related to prevailing interest rate changes. You could even consider locking in short-term individual bonds (not necessarily corporates but perhaps a municipal bond, depending on your tax bracket) for a specific upcoming liquidity need – such as a tax payment this coming April, if the rates are attractive enough.
After sharp market moves as we have experienced, it is even more important than ever for investors to look for opportunities to rebalance their portfolios. Some of the best opportunities for long-term success can be uncovered during down market cycles. During the rebalancing process, one additional strategy to consider involves tax loss optimization (or “harvesting”) – banking paper losses to reduce your future tax burden. In doing so, you can position your portfolio for higher returns and maximum tax efficiency. Long gone are the days of “buy and hold” – even in the bond space. If you want to keep more tax dollars in your pocket, there is no reason for you or your adviser not to be taking advantage of this.
The key to achieving optimal portfolio allocations through rebalancing and tax-loss harvesting is thoughtful asset allocation and security selection. It's highly advisable to seek the expert guidance of your investment adviser.
Navigating the Inverted Yield Curve
Generally, an inverted yield curve is not good news for the economy. But that doesn't mean yield-seeking investors need to cut and run. During a rising rate environment like we have seen this year, flexibility is more important than ever. Taking advantage of nimble bond fund managers who can reshuffle their underlying holdings to “float” higher along with general market rates, is absolutely critical.
Along with duration positioning, one final aspect of your bond portfolio to consider is the underlying credit quality and the amount of credit risk you are willing to take on. When rates are rising, it can cause a slowdown in the economy, which makes it harder for companies to service their debt. Chasing the highest-yielding bonds, without consideration of the underlying credit quality of the issuer, exposes you to levels of credit risk and potential defaults that should be avoided, or at the very least severely limited.
In this volatile and uncertain market environment, the one thing investors shouldn't do is panic. Markets always move in cycles, and this one shall also pass. In the meantime, with some thoughtful planning and strategic adjustments such as those described above, there are still some fixed-income opportunities to be had.
About the author: Dan Trumbower
Dan Trumbower, CFP®, is a senior wealth advisor at Halpern Financial, a fee-only, independent, fiduciary wealth management firm in Rockville, MD, and Ashburn, VA. Dan received a BSBA in Finance from Coastal Carolina University, and is a CFP® professional and has special expertise in financial issues affecting key executives of large corporations (such as restricted stock awards, incentive and NQ stock options along with NUA distributions from employer savings plans).