Have you seen a disaster movie in which the threat keeps getting worse and worse? In the 1997 film Titanic, it is the rising frigid water that menaces and ultimately overwhelms the ill-fated ship.
Unfortunately for bond investors today, escalating interest rates are analogous to the rising waters that swallow the ship.
Fortunately, the damage to portfolios this past spring and summer has a silver lining. It served as a helpful reminderafter 30 years of declinesthat rates can rise and create havoc.
While investors already have hit the iceberg and suffered some damage to their portfolios, they are still in the concerned category rather than panicked. Indeed, this minor damage can help us achieve the right frame of mind to plan for the future.
We will soon have a rising tide of interest rates that inflicts more serious pain. And bonds won't be alone, as high-yielding stocks and other income-generating investments are likely to get hit too.
What can we do as professional advisors to help our clients survive the coming rise in rates?
We must first convince them that this is a serious situation and that we cannot count on the Coast Guard to save us. We must take the proper steps to save ourselves.
LIFE RAFT MOST OF THE TIME
Ordinarily bonds are a source of stability. They create regular income and are much less volatile than many alternative investments.
They are a great life raft most of the time. Additionally, when stocks do poorly, bonds often rally, acting as a hedge against poor stock returns.
For the last 30 years, falling rates have provided investors with a boost to returns. With rates currently in the steerage deck, it is hard to believe they can go any lower. Bonds, which normally act as buoyancy, might be looking like ballast. Instead of helping us float when in trouble, bonds may drag us down.
If bonds aren't going to act like bonds of the past, then what should we expect? Generally, we should see bonds decline in price slowly over the next few years, peppered with periods of rapid price changes, both up and down.
Currently, the yield-to-maturity of the bond market is only 3.5%, which I consider to be the maximum possible return of bonds over the next several years. We will be lucky to keep our noses above the rising water.
A realization of interest rates' most likely path being upward is dawning on people at different times and with different amounts of alarm. Some believe the increases will be so slow and in such a distant future that immediate action is uncalled for. Some are alarmed.
One firm has gone so far as to inform clients who have large bond holdings that they are no longer categorized as conservative investors but instead as aggressive. This might be going a bit far, but the reading is that our happy tailwind of the last 30 years is over and a headwind is picking up.
SIZE OF PRICE DROP MATTERS
Reducing duration, and careful distribution of investments on the yield curve, will dampen the effects of rising rates.
When rates rise as they did in the second and third quarters of this year, bond prices decline. If the increase in rates is small and the price drop is small, the total return for an investor could remain positive as interest earned offsets the losses. The disappointment for investors in the second and third quarters was that the magnitude of the drop in prices overwhelmed their interest earned, giving them net losses. When interest yields are low, they can be easily overwhelmed.
Many bond investors, particularly high-net-worth investors, consider their portfolios to be largely buy-and-hold. They reason that future increases and decreases in bond prices are not a concern for them. If they are willing to hold their bonds to maturity, then interim losses are a minor concern.
I believe this attitude will hold them in good stead for small losses. But when a bond bought at $100 is now worth $85, will they still be happy holding it for eight more years to maturity? Or will they instead question their strategy and panic?
In the 1970s and early 80s, there were many buy-and-holders who bailed out. Running through some potential scenarios with clients makes sense in judging their tolerance for paper losses.
Looking at alternative ways to generate income other than bonds also may make sense.
Stocks with above-average yields may help cover an income gap caused by a less aggressive bond portfolio. Stocks with less interest sensitivity should also hold up better in a rising-rate environment.
As rates rise, investors can increase their income over time. To be sure, this will create an income gap from temporarily reducing their existing bond holdings and reducing duration of their portfolios. But it will be rewarded with a more rapid increase in income. Lower-yielding bonds will be replaced by higher-yielding ones, and eventually by longer duration bonds that should yield even more.
But a temporary reduction in income is unacceptable for some, and other plans must be made. For these clients, a few ways can usually be found to make their portfolios more defensive without cutting into income. This entails making sure all cash is invested or switching from non-dividend-paying stocks to dividend payers. And as rates rise, new investments will be at higher rates and generate an increasing flow of income.
So far, this is all about defense. Is there some offense to be played too by choosing investments that may profit from higher interest rates? Mutual fund companies and lending institutions are among possible good investment candidates.
Mutual fund companies with large exposures to short bond and money market funds, for example, will likely benefit as much of their fee income is being waived because of low interest rates. Lenders of all sorts might benefit as they raise lending rates. Their borrowing costs might rise, too, but with plentiful capital and liquidity they should rise more slowly.
Lastly, investors who buy mostly bonds may finally see an increase in their incomes. Where they spend their extra dollars is a guess, but restaurants offering early dinner specials may get crowded.
Brian Sullivan is president and chief investment officer of Regions Investment Management, a division of Regions Wealth Management.