Prospect for rising short-term rates. While long-term rates remain stable, short-term rates are set to rise next year in the United States as well as in the United Kingdom. Given the recent acceleration in the U.S. recovery, it’s possible that rates may rise earlier and at a brisker pace than many expect.
While this would likely help boost cash returns, it also means that bond investors may face losses. Bonds or bond funds with two- to five-year maturities (those most sensitive to changes in Federal Reserve (Fed) policy), have already witnessed increasing volatility just on the anticipation of a change in U.S. monetary policy.
Implications for Investors
All of the above suggests that investors should reconsider their bond market portfolios, if they haven’t already.
To be sure, there’s still an important place for traditional bond funds in a fixed income portfolio. While they’re light on yield, they can dampen portfolio volatility and offer a much needed hedge against an increasingly expensive equity market.
But in today’s less hospitable environment, investors should consider adopting a flexible approach for at least a portion of their bond portfolios.
With yields likely to be volatile, and some areas of the bond market feeling the effects more so than others, investors will want the ability to adjust their duration or rate exposure tactically (some extra duration actually helped during the first half of 2014). They’ll also want the ability to pursue niche areas of the bond market that still offer an attractive return-to-risk ratio.
A flexible approach, otherwise known as unconstrained investing, that looks for opportunities across a wide set of asset classes and markets can make such on-the-fly adjustments as needed. In short, it can potentially help investors with the increasingly difficult, but still critical, task of bond investing.
Sources: Bloomberg, BlackRock research
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog and you can find more of his posts here.