Bond Risk Rising with Rates
The Federal Reserve is raising interest rates. The current Fed Funds rate is 0.88%, up from zero in December 2015. By the end of 2018, the FOMC projection is for the Fed Funds rate to be 2.13%. The market expectation is 1.75%. In either case, the Fed Funds rate may more than double in the next couple of years and show at least a 1% increase.
The impact of a 1% rise in interest rates is negative for many bonds. Below is a chart showing the sensitivity of various bonds to a 1% increase in rates.
U.S. treasuries (UST) all lose value. So do inflation protected treasuries (TIPS), mortgage backed securities (MBS), U.S. aggregate bond portfolio (U.S. Aggregate), U.S. investment grade corporate bonds (IG corps), and municipal bonds (Munis).
The price returns on convertible, high yield (U.S. HY) and floating rate bonds are also negative. The total return of these three bond categories is positive because of the relatively high yield overcoming the loss of face value.
If interest rates rise by more than 1%, the bond problem becomes worse.
Bonds may no longer be a way to de-risk your portfolio. In the current market environment, bonds may be adding to the risk of loss.
The Active Equity Answer
World economies are growing. The chart below shows manufacturing activity by region and country. Numbers greater than 50 indicate expansion. Green represents growth. The time scale runs across the top from April 2015 on the left to March 2017 on the right. For March 2017, all areas are green(ish) and greater than 50 except for Greece, Korea and Brazil. The global PMI is 53.0. At 49.6, Brazil looks like it is gaining strength and may move into expansion territory soon.
In the Fed Minutes released on Wednesday, some Federal Open Market Committee participants viewed U.S. equity prices as “quite high” relative to standard valuations. The good news is the equity market is global. Year-to-date, equities from all major regions have outperformed bonds, REITs and commodities. International equities have been particularly strong.
Using disciplined, quantitative investment methods, many of our investment strategies have increased exposure to international equities year-to-date. Additionally, we apply quantitative risk mitigation rules to significantly reduce equity exposure when risk rises. We seek to achieve equity returns with downside protection. Bond problem solved. Solution: risk mitigated global equity with proactive downside protection.
After an eight year recovery in U.S. equities and a more than three decade bull market in bonds, we may be entering a new investment chapter. In the new chapter, active asset allocation outside of the U.S. and active portfolio risk mitigation may deliver materially better results with lower risk than the S&P 500 index and the traditional buy-and-hold 60%/40% stock/bond portfolio.
One of the keys to investing is sifting through all available information and sticking to a plan. Somehow, we need to control our emotions about something that is very important to each of us. We invite you to call or email anytime if you have questions about how we can help you with your wealth management. Please give us a call at (415) 249-6337 or email us at email@example.com to learn more.
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4/7/2017: Bond Risk Rising with Rates
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