Alan Greenspan just warned about the ramifications of rising interest rates and stagflation.  Bonds are the area of the market where rising interest rates will have the biggest adverse impact.  When Jim first entered the industry in 1986, one of the first pension plans he reviewed was a local union plan.  This plan invested 100% of its assets in US Treasury Notes in the late 70’s.  The returns from 1975-1980 were abysmal – generating a loss greater than 25% in value over that time due to rising interest rates.  Today, with a 40 year bull market in bonds in the rear view mirror, many investors are unaware that rising interest rates are detrimental for bonds.  Another little known fact is the longer the maturity of the bond, the bigger the potential loss during a period of rising rates.

All things being equal, a higher yield cushions the negative impact on bond prices when interest rates are rising.  Todays low yield gives very little cushion.  Therefore, the impact of rising interest rates will be even greater on bond prices today than it has been in the past.  Many investors do not understand the risks in their bond portfolio.  That can be seen as investors continue to invest money in “total return” bond funds such as Pimco Income Fund and Vanguard Total Bond Market Index Fund.  These funds are the 6th and 7th ranked funds respectively in terms of total cash inflows year-to-date.  These are huge funds with the PIMCO Income Fund having more than $130 billion in assets while the Vanguard Total Bond Market Fund has more than $180 billion in assets.  Because of their size, these funds won’t have the flexibility to protect client assets in a rising interest rate environment.  In addition, these funds will likely experience significant outflows once people realize their principal is going down in value which will only serve to exacerbate the fall in bond prices.

What impact does this have on your Fixed Income Portfolio?

We have structured the fixed income portion of our clients’ portfolios to be more defensive, guarding against a rising interest rate environment.  We have reduced both the interest rate risk as well as the credit risk.  This is not a time to be aggressive with your bond portfolio.  We have added a non-traded REIT to our clients’ fixed income portfolio.  This REIT invests in high quality real properties.  Not only do we like the investment on a stand alone basis, but we think there are several other key aspects this investment brings to the overall portfolio including:

  • portfolio diversification;
  • low correlation to stocks and bonds;
  • reliable income stream; and
  • a hedge against inflation as real estate tends to hold its value during inflationary environments.

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