For those in or near retirement who traditionally allocate a portion of their portfolio to bonds, bond funds, money market accounts, certificates of deposit (CD), and fixed-rate annuities, the uncertainty cloud hanging over interest rates in 2016 is a very big deal.
With the inverse relationship between bond prices and interest rates, investors have had to be creative in recent years to squeeze juice from fixed-income diversifiers. To be sure, savers have been broadly hurt from the Federal Reserve’s policy to keep interest rates near zero—they were north of 5% in 2006, ahead of the recession. And there’s renewed uncertainty on when interest rates might rise, something that only complicates the investing picture. But fixed-income products can still offer a measure of short-term protection against riskier assets in a portfolio.
"This is a market concerned about the growth prospects of China and the continued slide in crude oil,” says Craig Laffman, director, fixed income trading and syndicate at TD Ameritrade. “Fixed-income investors are likely to remain focused on central banks as other leading global banks are loosening rate policy, while the U.S. has dug in.”
But remember central banks “can be like Zeus with thunderbolts—swift and furious—and the market is likely to follow their direction," he says.
As recently as a few months ago, those rock-bottom interest rates weren’t anticipated to last long. People up and down Wall Street and Main Street expected U.S. rates to start going higher, thanks to Fed suggestions that they would. In December they did, when the Fed nudged them to a range of 0.25% to 0.5%, the first move in short-term rates in nearly a decade. Fed research and meeting minutes at that time revealed central bank estimations for four rate hikes in 2016, roughly one each quarter. But then the new year arrived and with it a fresh retreat for China’s economy, reluctance among consumers to spend their gasoline savings, so-so earnings, and a global stock retreat.
The Fed, already locked in a pretty good arm wrestle between hawks and doves anyway, went idle. Members remained optimistic about U.S. growth prospects but said they saw little immediate threat that flaring inflation accompanies that growth. So the already go-slow Fed is seen as potentially putting the brakes on steady rate hikes this year. Futures traders, for example, are only pricing in a slim chance for a rate hike in September, with the probability of a hike before the end of 2016 just pushing above 50%
Why Does It Matter for Bonds?
A higher interest-rate climate, while it can cut the worth of existing bonds in portfolios, also offers potentially higher interest payments on newly purchased bonds. It can once again make bond investments competitive relative to higher-yielding dividend stocks and other investments.
It’s the nature of this relationship that leads some investors to consider bond laddering as a more flexible response to a potentially changing interest-rate climate over the long haul, says Laffman.
He’s also quick to point out that abandoning fixed income all together can be especially risky for retirees who want a variety of potential income streams. Instead, bond investors may need to widen their search to include higher-rated corporate bonds or municipal bonds that have certain tax advantages that can appeal to high-net-worth investors.
Retirees may also want to keep their eye on the long term. Short-term bond market volatility could persist and could make interest rate-watching unduly tortuous. When Fed chair Janet Yellen spoke to Congress in mid-February, her dovishness sent Treasury yields lower. The spread between 10-year and two-year yields moved to the flattest it had been since December 2007 as traders adjusted for the prospect of slower growth and little action at the short end of the yield curve.
But there’s good news for retirees and investors at all stages of their journey: Most experts don’t think the flat Treasury curve signals an imminent recession. Flattening is the result of a slower-moving Fed, yes, but it’s also driven by international demand for U.S. bonds as they exit trouble spots elsewhere. Their demand drives up prices and drives down yields. For retirees, that could help support overall bond-market and credit-market health that could keep fixed income a valuable piece to a well-balanced portfolio.
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