For the last 30 years, interest rates have been going in just one direction, as the graph below illustrates.
For its part, the Fed has at least put a time frame on its quantitative easing program, which strives to — and so far has — kept rates low. Specifically, the Fed will continue to exert downward pressure on interest rates until 2015, at which time it believes that the unemployment rate will be 6.5%. Others feel rates may rise sooner, with estimates ranging from latter 2013 to 2014.
Rates have been going down for so long that among many investors – including some I admire greatly – low, low rates have taken on an air of permanence. In investing and wealth preservation, this is the first cardinal sin. Nothing is permanent.
When this “unexpected” change occurs, the bubble that’s building in bonds will burst and capital will be lost. Remember, the value of bonds runs inversely to interest rates. So all these years, savvy bond investors and traders have been able to win, and win big. Remember, “the trend is your friend.”
That is, until it isn’t anymore. To position yourself for a turnaround in interest rates, I recommend these five steps.
Reduce the duration of your fixed income portfolio. Duration is expressed in years, and measures a bond’s sensitivity to changes in interest rates; the longer the duration, the more sensitive a bond is to changes in interest rates. Since we believe rates are going up, the natural byproduct of this thinking is shortening the duration of your fixed income portfolio. The GMG Defensive Beta Fund, which I co-manage, is designed to provide equity-like returns with less volatility than the broader market. To help achieve the lower volatility, we hold bonds. The average maturity of bonds we own is less than four years.
Take money off the table. If you own bonds, either directly or through funds, chances are you’ve got a profit. That is, there are the interest payments, but above and beyond that, the value of your bond holdings has probably risen. Unless you expect interest rates to drop further, take advantage of this capital appreciation — by selling and taking the profits (and running). In our view, capital gains opportunities are not going to get better than they are right now.
Go for yield. Granted, yield is a little harder to come by these days, but it’s out there. In this arena, I like the State Street Short-term High Yield ETF (NYSEARCA:SJNK), which has a yield of about 6 ¾%.
Go Rainbow. Mix high-quality corporate bonds and municipal bonds. For corporate bonds, stay with AA rated or better. On the muni side, stick with general obligation bonds, as GO bonds are not tied to a specific revenue source from a state or municipality, generally making them safer.
Cherry-pick. Be picky. If or as you sell off some of your existing bonds or other holdings, incorporate some high-quality high-dividend paying stocks. Don’t think of these as a replacement for your bond portfolio, but rather as a supplement. Many stocks have a beta that is about half that of the S&P 500 (INDEXSP:.INX) as a whole, which is very similar to some long-dated bonds.
