By Stan Choe
AP Business Writer
NEW YORK (AP) - Rising rates don't have to mean despair for bond-fund investors.
Yes, the Federal Reserve raised short-term rates last Wednesday, the latest move higher in what economists expect to be a long campaign. Bond investors have historically seen rising rates as the enemy because they result in falling prices for the bonds they own.
High-profile bond fund managers are urging their shareholders not to lose hope. Expect lower returns than in earlier years of the decades-long bull market, for sure, but don't give up. Ford O'Neil of the Fidelity Total Bond fund and Mary Ellen Stanek and Warren Pierson of the Baird Core Plus Bond fund were all nominees for this past year's Morningstar fixed-income fund manager of the year. (O'Neil's team won the prize.) Here are some points they're making:
- Bonds will stay in demand, which should help keep a lid on rates.
Populations around the world are getting older. As they move into retirement, just like the Baby Boomers are doing, they'll be looking for investments that provide income. That should set a base level of demand for bonds, regardless of how many times the Federal Reserve pushes rates higher.
Plus, the world has been hungry for income given how the Federal Reserve kept short-term rates pinned at nearly zero for years following the 2008 financial crisis. That means many investors will pounce on anything with a higher yield, Stanek says. That demand from insurance companies, pension funds and other investors looking for income should also help limit the rise in rates.
Pierson says the yield on the 10-year Treasury could climb as high as 3 percent this year, up from its current 2.51 percent, but he doesn't see it going much above that.
- There is an upside to rising rates.
When rates rise, prices for older bonds fall, but new bonds pay more in interest. As long as the rise is gradual, the higher income can offset the price declines for older bonds.
Bond-fund managers say they'll appreciate working in a market where prices and yields will again be determined more by economic growth, inflation and other traditional measures, rather than what the Federal Reserve is doing.
"The Federal Reserve has moved from being referees of the game to being participants on the field," O'Neil says. "If we do get what we expect - modestly rising interest rates - we're on the path to normalization. And that, to me, is a really good outcome."
- All the potential change coming out of Washington is dizzying.
Not only are investors wondering about the pace of rate increases from the Fed, they also have to contend with the wide range of possibilities coming out of Capitol Hill and the White House.
Republicans have talked about a tax cut, but they haven't given many details. They've talked about revamping trade deals, but investors don't know how that will play out. An infrastructure plan could jolt the economy. But, again, the details. Each of those issues could have a big impact on the bond market, but managers don't know which way they'll go.
"It's important to war-game and think about your portfolio and all the risks," says O'Neil. "But it's impossible to set up your portfolio for one of a dozen outcomes, because it's very hard to understand what the probabilities look like for each of those potential changes."
- Control what you can.
"The range of possible outcomes is so wide, so we say: Control what you can control," Stanek says. For regular investors, that includes keeping costs low by investing in funds with low expense ratios. With returns likely to be lower, keeping as much as possible of it is key.
For Stanek, that means keeping her fund well diversified. She doesn't want to concentrate too much on any one area of the bond market, whether that's high-yield bonds or investment-grade corporate bonds, when there's so much uncertainty about who the winners and losers will be.
Her Baird Core Plus Bond fund can put up to 20 percent of its money in high-yield bonds. These, as their name suggests, pay higher yields than investment-grade bonds, but they come with a higher risk of default. The Baird Core Plus Bond fund had only 8 percent in high-yield at the start of the year, including about 2 percent in high-yield corporate bonds.
- Expect more volatility than in prior years, and lower returns.
With yields low, bonds are producing relatively small amounts of income. And with rates likely rising, their prices are more likely to go down than up.
The other thing that bond investors worry about most, inflation, could be another risk. It's been nudging up, and an unexpected rip higher would pummel bond prices.
The smooth ride bond funds provided for many years is also likely over. With the Fed finally back in the mode of raising rates, bond investors are constantly pricing in - and out - their expectations for upcoming hikes, and bond prices move up and down accordingly.
"We probably are in a rising-rate environment," Pierson says, "but very rarely do you see rates just go up continuously."
Published: Mon, Mar 20, 2017