The U.S. stock market, measured by the S&P 500, reached record high levels in 2013 and turned in its best performance since 1997. The bond market did not do well at all. Investment grade bonds suffered their first loss since 1999. The Barclays Aggregate Index is the most widely followed bond index. It finished the year with a 2.03% loss, making 2013 the second-worst year since 1980.
An improving economy and lower unemployment have raised concerns that the historical low interest rate environment will soon end. The bond market’s troubles began last May, when Fed Chairman Ben Bernanke suggested the Fed may soon “taper” its quantitative easing policy (QE3). The Fed’s QE3 program buys $85 billion of government debt a month. The Fed announced in December it will “modestly” cut back on its monthly asset purchases from $85 billion to $75 billion dollars.
These conditions will likely continue in 2014. The trend will put continued pressure on interest rates to move higher and bond prices to move lower. Should investors avoid bonds until yields stabilize?
Let’s review the role of bonds as part of an investment strategy. While bond prices do fluctuate, they are less volatile than stocks. Allocating a portion of investment assets to bonds provides a place to store some of the gains from the equity portion of the portfolio when stock prices are rising. To minimize the chance of loss in our bond allocation, we utilize a fixed income technique called laddering. Our fixed income portfolios have a maximum maturity of five years.
Laddering assures a portion of the fixed income portfolio is maturing on a regular basis. Ideally, 20% of the fixed income portfolio matures every 12 months. Bonds mature at face value, so the maturing bonds are not affected by rising interest rates. Proceeds of the maturing bonds can be used to meet a client’s liquidity needs, buy equities if the stock market is down, or buy a new bond if the portfolio is already balanced.
Bond ladders are an efficient way to manage interest rate risk in a fixed income portfolio. Take steps today to minimize the impact of higher interest rates on your fixed income holdings.