Today I was listening to a Fund Flows Report from Morningstar, which is an overview of the money flowing in and out of mutual funds and ETFs over the year.  One trend that has remained consistent over the past 18 or so months is that investors are piling into bond funds.  Some media outlets have suggested there might even be a bond “bubble.”  I can see how some might see a bubble developing in, say, high-yield (junk) or emerging market bonds, but not in the broader bond market.  There just isn’t irrational euphoria in the asset class.

There are several drivers for increased flows into bond funds: increased risk aversion, low yields on cash investments, and higher savings rates.  The biggest driver, in my opinion, is that many investors moving toward retirement have a lower risk tolerance than they realized and may have been under-allocated to bonds compared to equities.  It’s difficult to predict whether this behavior will continue, but it’s clear that the U.S. population isn’t getting any younger.

The most common concern about fixed income I hear today is: what if interest rates begin to rise?    With interest rates at historically low levels, it seems inevitable that rates will rise at some point in the future.   When rates rise, bond prices fall.  But don’t let this well known fact deter you from maintaining fixed income investments.  It is the interest payments that fixed income investments make that is important, not the changes in price.

According to Charles Schwab, more than 90% of the total return since 1976 generated from a broadly balanced portfolio of U.S. investment-grade Treasury, agency and corporate bonds has come from interest payments as opposed to change in price.  You can see this in the chart below.

So rising rates won’t cripple your portfolio, but there are still several steps we recommend taking to better position yourself for a rising rate environment.

Limit maturities by choosing short-term bonds or bond funds, especially for money that you may need soon.  For this part of a portfolio, lower yield is less important than the lower potential for a drop in the value should rates rise.

Stick to intermediate-term bonds or bond funds for the core of your portfolio.  The benefit of rising rates decreases for each year of added maturity after a certain point on the yield curve.  The “sweet spot” for all but the most income-oriented investors tends to be intermediate-term (five- to ten-year maturities).

Include higher-yielding bonds such as corporate bonds (in moderation and depending on your tolerance for credit risk) to temper the impact if rates rise.  Prices of bonds with higher coupons, like corporate bonds, tend to fall less than bonds with lower coupons, like Treasuries.  Of course, the risk is higher for corporate bonds if economic or credit conditions change.

Peter Lazaroff, Investment Analyst