NEW YORK (FMD Capital Management) -- Income investors face a brave new world in 2014, punctuated by real interest rates trending higher and the Federal Reserve slowly reducing the pace of quantitative easing measures. This has led to fears of a massive shift from traditional fixed income to equities and alternative investments. In fact, many have abandoned bonds altogether and have sworn off owning them for the foreseeable future.
On the flip side, many stalwart income seekers have shifted to short-duration or credit-sensitive holdings, which have thrived in 2013.
The key to success in 2014 will be to strike a balance between credit, duration and sector exposure to achieve positive returns in fixed income. It can't be discounted that retirees and other conservative investors need income, diversification and low volatility. Bonds shouldn't be ignored. Rather, hold them strategically, with the knowledge that there may be speed bumps along the way to your investment goals.
These are my thoughts on opportunities and risk in bonds over the next 12 months.
Most investors perceive rising interest rates to be the biggest risk to bond holders over the next year. And there are a number of ways that ETF investors can combat rising rates. One such method would be to purchase a rising-rate fund such as the ProShares 20+ Year Short Treasury ETF (TBF). This fund essentially moves in the same direction as long-term interest rates and can hedge off a portion of the volatility in your fixed-income portfolio.
At this stage, it's important to remember that interest rates have already risen considerably since their 2013 low. They will more than likely continue to meander through 2014 with a variety of ups and downs along the way. If you are planning on shorting treasury bonds, make sure that you do so with a risk management approach that takes into account the potential for deflation.
Another method of insulation from bumps would be to shorten your average portfolio duration. An example of would be to move from the iShares Aggregate Bond ETF (AGG) to the Vanguard Short Duration Bond ETF (BSV). This would lower the effective maturity dates of the bonds in your portfolio, but also quite drastically reduce your monthly income stream. If you are dependent on the dividends from your investments, this strategy may eat into your capital over time.
Both of these strategies have been effective against rising rates in 2013, as billions of dollars have shifted in this general direction. However, there are a host of perils other than rising rates that may appear.
By shortening bond duration, many investors have taken on more credit risk than historical norms. This has created what many describe as a bubble in high yield debt. That bubble has the potential to deflate if we start to see an economic slowdown or a rush for the exits. A stumble in the stock market could trip up junk bonds and send money fleeing from equities and credit-sensitive holdings.
Right now we are still in an uptrend with respect to high yield, bank loans and convertible bonds. That's why I am recommending you hold onto your exposure in these areas. However, I am closely monitoring these high yield sectors for signs of a reversal. That would warrant moving a portion of capital back to higher quality holdings such as the iShares Investment Grade Corporate Bond ETF (LQD) or the iShares MBS ETF (MBB). These ETFs, along with treasuries, would likely do well in a deflationary environment alongside a flight to quality.
Another correlation I am monitoring with respect to high yield is the divergence between U.S. high yield corporate debt and emerging market bonds of a similar credit quality. Consider that the iShares High Yield Corporate Bond ETF (HYG) is trading near all-time highs and has a comparable yield to the WisdomTree Emerging Market Corporate Bond ETF (EMCB). However, EMCB is still more than 5% off its high water mark. I expect that this divergence will eventually correct and we could see money flow into emerging markets as fixed-income investors find more value and diversification overseas next year.
To pick the right fixed income ETF or mutual fund for your needs, you must evaluate your risk tolerance and investment objectives. You should do some analysis of top-performing funds from previous years. Ask yourself how a fund will perform under certain scenarios. If the Fed decides to speed up or slow down its stimulus taper, you may have to shift your portfolio to cope with changing dynamics. In addition, it's important to keep an eye on the health of equity and credit-sensitive markets. They will impact the bond market in the coming year ahead.
One of my favorite core holdings is the actively managed Pimco Income Fund (PONDX), which takes a multisector approach to the bond market. The managers select areas they think will outperform. The fund has done a fantastic job of managing interest rate risk in 2013, as well as taking advantage of available opportunities both inside and outside the U.S. This has led to 2013 returns approaching 4.5%, an effective duration of less than 5 years and a current 30-day SEC yield of nearly 4%.
In a series of upcoming articles, I will detail my thoughts on equities and alternative investments for income investors in 2014. As you are evaluating your portfolio heading into the new year, make sure that you stay balanced and agile. That way you are prepared with a game plan to shift your asset allocation when needed and overcome any obstacles that you may encounter.
Here's to a healthy and wealthy New Year!
At the time of publication the author held HYG but had no position in any of the other securities mentioned.
This article was written by an independent contributor, separate from TheStreet's regular news coverage.