Despite the current activities and news coming out of Washington, there continue to be many other risks and opportunities in the investment markets that impact your portfolio. One aspect we would like to revisit in this article is the impact of interest rates and bonds on your portfolio. Concerns about rising interest rates have been widely discussed in the financial press the past 6-7 years, and there seems to be renewed media attention in the past few weeks that interest rates in the United States could increase. Before we share our thoughts on this topic, it is important to remember two things: 1) there is an inverse relationship between interest rates and bonds – in other words, as interest rates rise, bond prices typically fall, and vice versa; and 2) though the Federal Reserve has a direct impact on short-term interest rates, it does not control long-term rates (i.e., 5+ years) which are governed more by market forces than by Central Bank intervention.
Cloudy Crystal Balls
While some pundits want us to believe they have a crystal ball, the reality is that no one knows where rates will be 1, 5, or 50 years from now – not even the Federal Reserve. To illustrate the risk of forecasting, many market pundits have warned about high interest rates since the end of the global financial crisis of 2008/09. However, rates have continued to decline, and the 10-year Treasury bond is now at 2.4%- a low figure compared to the historical average of 6.1%*.
Many of the interest rate warnings have come from highly intelligent and sophisticated investors. However, due to the multitude of factors influencing interest rates, it is virtually impossible to predict the magnitude or even the direction of future rate changes. In fact, there are strong voices on both sides of the debate. To illustrate with an example, I recently attended CFA Institute’s Fixed Income Panel here in San Francisco, and the general view among several of the panel experts was that interest rates would likely stay at current levels for several years. In contrast, there are a host of articles and predictions in both the financial and mainstream press warning about everything from negative to extremely high interest rates. Finally, even if all pundits agreed, “the market is always right, even when the market is wrong” as the old saying goes. In other words, one only bets against the market at one’s peril.
Bond Allocation at Private Ocean
Here at Private Ocean, your portfolio is constructed to fit your long-term needs and goals and weather many types of market outcomes. We think it is imprudent to gamble your wealth on just one or even a handful of scenarios, and that a well-diversified portfolio is the best strategy to prepare for the future. Not only is the bond portion of your portfolio highly diversified across thousands of bonds in a multitude of sectors, maturities and credit qualities, but the rest of your portfolio is driven by factors that often move opposite of bonds. For example, stocks are likely to perform better in a moderately rising interest rate environment, offsetting the negative impact on bonds. And in case we were to go through another large stock market decline, it is good to lean on the safety of bonds when those stocks are suffering.
Lower Interest Rate Risk
Due to our diversified approach and our focus on avoiding uncompensated risks, the duration of your bond allocation is currently shorter than that of the Barclays Aggregate Index**. Duration is a measure of interest rate risk, and the higher the duration, the greater the interest rate risk. As a consequence of the lower duration in Private Ocean portfolios, your portfolio should be less sensitive to changes in interest rates compared to the index.
Rising Rates are Not Necessarily Bad
What is often forgotten when discussing bonds and rising interest rates is that when a bond matures it can be reinvested at the then higher prevailing rate. While an increase in interest rates would initially reduce the value of bonds, any interest and principal distributions can be reinvested at the higher interest rate. For long-term investors, this means your bond funds should ultimately provide you with higher interest payments.