Limber Up: 3 Reasons to Keep Your Bond Portfolio Flexible

Source: Getty Images

Speaking in June of 2013 at a time when the Federal Reserve had the monetary throttle wide open and quantitative easing was running at $85 billion per month, Pimco Founder and Chief Investment Officer Bill Gross told investors that his fund wouldn’t be expecting big returns. Monetary easing had pushed interest rates to historic lows and had provided octane for equities, and taper talk had made both those markets volatile. ”We believe caution is warranted not just for fixed income investors, but for investors in all risk assets,” wrote Gross.

Pimco’s Total Return Fund, the world’s largest bond fund and one of the most successful, suffered eight consecutive months of outflows, losing $4.2 billion worth of assets, and ended up posting its worst performance since 1994. In all, investors pulled a record $80 billion from bond mutual funds in 2013.

The situation in 2014 is different, but not necessarily better. The taper was kicked off with relatively little turmoil, but the trajectory of the market is still opaque. The S&P 500 is up 2.3 percent year to date, the Dow is off fractionally, while the Nasdaq has showed some life — climbing 5.2 percent — but few investors are expecting the same kind of returns that siphoned money away from the bond market in 2013. At the same time, the yield on the 10-year Treasury note has declined, falling about 30 basis points year to date.

If you ask Rick Rieder, Chief Investment Officer of Fundamental Fixed Income at BlackRock Inc. (NYSE:BLK), there are three important factors that will have a major impact on the way that investors should think about bond investing in the coming year — and, hopefully, help investors avoid any unnecessary losses.

Source: Getty Images

1. “Interest rates should move higher over the coming year.”

The Fed’s open-ended QE program put downward pressure on interest rates for much of 2013. The yield on the benchmark 10-year Treasury fell as low as 1.6 percent in May of that year, shortly before Pimco warned investors about the rocky road ahead. BlackRock’s Rieder attributes the decline in early 2014 to “a combination of investor risk aversion sparked by problems in emerging markets and weakness in economic data, exacerbated in part by weather disruptions.”

Rates climbed toward 3 percent by September as talk of the taper heated up, and the market since then has been characterized by volatility. The yield on the 10-year T note is down about 8.3 percent this year to date at 2.8 percent.

But between the taper, the recovering economy, and the expiration of short-term headwinds, Rieder doesn’t expect rates to stay at 2.8 percent forever. Rieder expects a “rising rate environment,” in which making appropriate investment decisions can be difficult. Remember, as rates rise prices fall, rapid changes in rates can also mean a rapid change in the price of the bonds in a portfolio.

Source: http://www.flickr.com/photos/teubig/

2. “Rates at the ‘belly’ of the yield curve will rise more dramatically than long-term rates.”

In a way, investors can use duration to measure a bonds sensitivity to interest rate changes, and in general, lower duration bonds are less sensitive to changes rising interest rates. With this in mind, it’s easy to see why investors flocked into shorter maturity fixed income investments and out of longer-maturity investments in 2013. In a rising rate environment, short duration investments tend to do better.

Investors pulled about $8.3 billion from longer-duration ETFs and funneled nearly $36 billion into shorter-duration ETFs and were rewarded for their repositioning. In 2013, the iShares 1-3 Year Treasury Bond ETF (NYSE:SHY), with an average duration of 1.84 years, gained 0.23 percent, the iShares 7-10 Year Treasury Bond ETF (NYSE:IEF), with an average duration of 7.53 years, lost 6.12 percent, and the iShares 20+ Year Treasury Bond ETF (NYSE:TLT) lost 13.91 percent.

Source: http://www.flickr.com/photos/teegardin/

3. “Volatility among and within fixed income sectors should be high.”

This may be self explanatory, but it also may be the most important thing to keep in mind. Rieder reports that BlackRock generally has an “unfavorable view toward Treasuries” because it will be hard to invest in them efficiently in a volatile environment.

That said, there are still some compelling fixed-income strategies to follow. Rieder and his team do like longer-term Treasuries (where rates aren’t expected to change as dramatically), municipal bonds, and Treasury inflation protected securities, or TIPS. Inflation has been low to nonexistent recently, but the taper means the gradual end of one of the major disinflationary pressures.