The Federal Open Market Committee (FOMC) meeting has concluded and bond investors are still nervous about a possible rate hike coming later in 2015.
Most bond funds are in the negative for the year. Price action on bonds, as measured by iShares Core US Aggregate Bond (AGG), show a 0.3% decline in just the past month. Year-to-date AGG is down 0.8%. And downward pressure is likely to continue throughout the remainder of 2015 until investors have more clarity on Fed rate policy and the longer-term trajectory for interest rates.
Does the proximity to rising rates mean that investors should dump their bond funds now? The answer to this question begins with the same two words that I begin every similar question investors ask me: That depends.
Should Investors Sell Bond Funds Now?
Short-term investors are wise to stay away from bond funds or any kind of investment type with market risk in any market environment, especially this one. So if you need your money in six months, you might do better keeping it in cash.
But most intermediate- to long-term investors should continue to let their investment objectives lead their decisions, not the whims of short-term price movements or media noise. These investors need not be concerned with the timing of a rate hike but rather what the path of interest rate increases will look like over the next few years.
The bottom line on the FOMC statement for investors is that Fed policy is largely unchanged as expected and the door is still open for a rate hike in September. But a lower rate path indicates a slightly more dovish Fed resigned to a low interest rate environment at least through 2017.
With that said, there are some types of bond funds that tactical investors should avoid or underweight now.
Worst Types of Bond Funds to Hold Now
Although the hype over interest rate concerns is likely to be overblown, the psychology of investors, the reality of rising rates, and global economic concerns will be a bigger problem for these types of bond funds:
- Long-Term Bond Funds: The longer the maturity (or longer average duration for bond funds to be technically correct), the bigger the price decline in rising interest rate environments. For this reason, long-term bond funds are said to have high interest rate sensitivity. For example, a highly interest-rate sensitive fund like Pimco 25+ Year Zero Coupon US Treasury (ZROZ) has declined in price year-to-date by nearly 10%. But in 2014, when interest rates remained unexpectedly low, ZROZ had a huge price jump of 44%.
- High-Yield Bond Funds: Don’t make the mistake of focusing on interest rates and missing a potentially bigger problem for bond fund prices — credit risk. High-yield bond funds are providing great yields for investors in a low-yield environment and have also held up on the price side thus far in 2015. For example, one of the best high-yield bond funds, Fidelity Capital & Income (FAGIX), is yielding 3.86% and sitting on a nice year-to-date gain of 2.5%. But when things turn south and the flight to safety hits the bond market, investors need to be prepared for stock-like declines. In 2008, in the midst of the last big downturn, FAGIX was hit with a 30% drop.
- Global & Emerging Markets Bond Funds: While bond investors watch the Fed, they should also be wary of negative developments outside of the U.S., such as the current one with the Greek debt crisis. In general, global bond funds and emerging bond funds aren’t getting hit too hard now but that could change quickly, as is the case for high-yield bonds. For example, an otherwise outstanding fund like T. Rowe Price Emerging Markets (PREMX), is sitting on a category-beating 1.2% gain year-to-date. But when global markets tanked in 2008, PREMX was hit with a decline of -17.1%, which compares to a 5.2% gain that year for the Barclays Aggregate Bond Index.
Bottom Line
Long-term investors can pretty much ignore the short-term noise on falling rates and a massive flight to safety when U.S. and global economies turn south again. Just don’t play a short-term game of chicken with bond funds that are most likely to lose in the short term, such as those mentioned here.
As of this writing, Kent Thune did not hold a position in any of the aforementioned securities. However he holds AGG in some client accounts. His No. 1 holding is his privately held investment advisory firm. Under no circumstances does this information represent a recommendation to buy or sell securities.
