Bonds and Asset Allocation
Updated: Nov 9, 2021
Investors have gotten fairly used to volatility when it comes to stocks. But not so much when it comes to bonds.
Bonds are supposed to be the stable, boring part of your portfolio, right? That is not always the case.
Just as investors have become accustomed to volatility in the stock markets, they have seen little movement in interest rates. And it is a fundamental principle for investing in bonds that market interest rates and bond prices generally move in opposite directions. That means when interest rates rise, prices of bonds fall.
We have seen inflation rising lately. This is part of the rebound as the economy recovers from the COVID-19 shutdown. According to Morgan Stanley’s mid-year outlook, economists expect U.S. core inflation to settle above 2%, which is higher than we have seen in the past several years. What’s more, the Federal Reserve tends to raise interest rates to cool down a rapidly growing economy to keep inflation from rising out of control. It is possible the Fed hikes rates in 2023.
Rising rates, then, affect the value of bonds by lowering return. This risk has led some investors to limit the amount of long-term bond funds in their portfolios. This does not mean bonds have no place in a well-balanced portfolio. It’s just helpful to consider your asset allocation in light of these risks. Bonds serve as a way to diversify the risk in your portfolio because they function differently from stocks. That counterweight has its advantages.
And even as the Federal Reserve suggests an increase for interest rates, the Fed has also signaled quite clearly the desire to keep rates low moving forward. Rates have been historically low and the Fed expects to keep them that way for the next couple years, at least.
Even as inflation has trended upward lately, many economists expect this increase to be temporary, as a result of the economy springing back to life. So don’t do anything drastic. “Take a breath and don’t overreact,” says Jurrien Timmer, Director of Global Macro for Fidelity Investments. “There are three things investors need to do: Have a plan, stick with that plan, and rebalance. Don’t sell something just because it’s going down, because it won’t go down forever.”
These are good suggestions: Have a plan, stick with that plan, and rebalance. If you do need to tweak the balance of your portfolio, there are a few options. It may be as simple as finding bond funds with shorter maturities. The longer the bond’s maturity, the greater the risk that changing interest rates negatively affect the bond’s value. Generally, bonds with longer maturities have higher interest rate risk than those with shorter maturities. Rebalancing might make sense based on stocks being at new highs. Your asset allocation may have changed because of changes in stock values.
Bonds still make sense to moderate risk to a diverse portfolio. And bonds help make regular distributions into that portfolio. While rising rates could make the bond market a bit messy, for investors seeking to generate income, higher yields mean more income. Or consider other areas of the market that can produce income, like dividend-paying stocks. There are many different options to consider.
At Brixton Capital Wealth Advisors, we work with our clients to customize plans that fit individual goals. We are happy to schedule time to go over your plan and asset allocation.