Bonds, which are supposed to be a sleep-at-night investment, are suddenly causing insomnia.
Worries about an eventual end to the Federal Reserve's ultra-easy monetary policy have pushed up interest rates in the past two months, and bond prices fall as rates rise. Instead of the steady gains they had come to expect, bond-fund investors are suffering short-term losses.
The shock has prompted some investors to rethink their bond portfolios. They're wondering if they should move exclusively into short-term bonds, which won't suffer as much from rising rates, or perhaps dump bonds entirely.
That would be a mistake, investing experts say. Bonds play a shock-absorber role in most portfolios, displaying less volatility than stocks or alternative investments. And people who try to time the market — even famous ones — are wrong as often as they are right.
Larry Swedroe, research director at Buckingham Asset Management, advises deciding on a bond allocation that's suitable for your risk tolerance and time horizon, and then sticking with it.
You may be absolutely convinced that the Fed is ready to end its bond-buying program next year, and start raising rates sometime after that, but that knowledge is worth less than you think. "What are the odds that the smart guys at Goldman ... are unaware of this?" Swedroe asked. "The current yield curve fully reflects the expected path of interest rates."
For a market-timing move to pay off, rates would have to go up faster than the market expects. If they follow the expected path — or rise more slowly, perhaps because a sluggish economy forces the Fed to keep its foot on the accelerator — dumping bonds or shortening maturities would be a losing move.
Scott Colbert, head of fixed income investing at Commerce Trust Co., ran a few simulations . He tested a buy-and-hold strategy involving intermediate-term bonds against a strategy that holds cash and short-term bonds for two years while rates are rising. After 10 years, it's almost a dead heat. The buy-and-hold investor wins in some simulations, while the scaredy-cat wins if rates rise more rapidly. The differences are tiny, though.
Colbert draws a couple of lessons from this exercise. First, any market-timing strategy involves tradeoffs. "The benefit of having avoided a modest interest rate rise is largely offset by the income you could have earned" by sitting tight, he said. "That should mollify the anxiety people feel about owning bonds today."
Second, higher interest rates are actually good for bond investors. Although bonds shrink in value at first, investors earn more interest as they reinvest over time. "Over a 10-year horizon, you absolutely benefit from higher rates," Colbert said.
It can be difficult to sit tight during what looks like an important transition, but sometimes, nothing is the right thing to do.
Consider the experience of Bill Gross, who manages the world's largest bond fund at Pacific Investment Management. He declared in March 2011 that he was avoiding Treasury bonds because rates couldn't go any lower — and the 10-year Treasury yield proceeded to drop by 2 percentage points in the next two years.
More recently, Gross has been right about Treasuries. The 10-year yield has risen about a percentage point from its April low, but that doesn't mean it will keep rising. In large measure, the Fed policy change that everyone's talking about has already been priced into the market.
Furthermore, the higher yields make bonds more attractive than they were a few months ago, not less so.
"A lot of investors have decided to head for the exits because the clouds showed up," said Gary Thayer, chief macro strategist at Wells Fargo Advisors. "It's not necessarily going to rain, and you could miss the best part of the ball game."