What You Really Need to Know to Play Rising Rates (and Win)

Keith Fitz-Gerald Jun 12, 2015
33 

Millions of investors are understandably flummoxed by the prospect of rising rates, and with good reason – it’s something that they’ve never had to contend with because interest rates have been on a one way trip down since 1981 when they peaked above 15%.

Naturally, Wall Street’s hype machine is in full gear and the headlines are terrifying. For every one telling you this isn’t a big deal there are 10 telling you it’s the end of the
financial universe as you know it.

Worse, they’ll have you believe that you’re some kind of moron to own bonds at the moment.

Neither one of these things is true. In fact, bonds are more relevant than ever.

Today we’re going to talk about why and what you need to know to successfully profit when Team Yellen finally makes its move. And, as usual, I’m going to give you three actionable steps you can take immediately as well as two specific recommendations that can help protect your money and profit even as others are left crying in their coupons.

Here’s why bonds matter more than ever.

Wall Street has done an exceptional job of fear-mongering when it comes to rising interest rates. Judging from the headlines, they’re the worst thing in the world to own right now:

“Bond Fund Investors Feel the Pain of Rising Rates” – USA Today

“Bond Investors Beware, History Is Not On Your Side” – Seeking Alpha

“Bonds Overvalued According to Three-Quarters of Investment Professionals” – Hedgeweek.com

If you’re shaking in your boots, I don’t blame you one iota. The current bond bull market is 34 years old and it’s been a one way trip as yields have fallen.

If you’re wondering why we’re talking about a bull market and I’m showing you a chart that’s headed lower, there’s a good reason. Yields and bond prices move in opposite directions. This means that prices rise as yields fall. Conversely, when yields (rates rise) bond prices fall.

On the surface, there’s a lot to be afraid of especially when the media is playing up comments from guys like “Bond King” Bill Gross, formerly of PIMCO now of Janus.

He appeared moments before I did on CNBC this past Wednesday noting that the Fed doesn’t “know the way home.” It was a thinly veiled innuendo meaning that the Fed hasn’t got a clue how to unwind the massive stimulus-related mess they’ve created not to mention hundreds of billions in toxic debt sludge they now own.

I couldn’t agree more strongly. But here’s the thing…rising rates are not a “one and done” situation and not every bond is not toxic.

In fact, bonds have played and will continue to play a very important role in your portfolio.

Let me show you why.

Bonds Are Ultimate Proof that Slow and Steady Secures Your Financial Future

From 1970 to 2014, bonds produced a compound annual return of 6.3% according to MarketWatch data. Equities turned in an average annual compound return of 11.8%. The inference, of course, is that bonds were an inferior investment. The implication from Wall Street is that they still are, especially when it’s a foregone conclusion that rates are going to rise.

Not so fast.

The typical bond portfolio over that time frame had a deviation of only 4.1% while stocks came in at 14.8%. What this means is that stocks subjected you and your money to a ride that was more than three times as volatile. Very few investors have the stomach for that.

The key takeaway here is that you want to use bonds in conjunction with your stocks and other investments.

The other whopper making the rounds right now is that “everybody is going to dump bonds” when the time comes.

That’s simply not true.

An estimated 75% of all U.S. government bonds owned are never sold. That’s because they’re purchased by institutional investors, hedge funds, insurance companies, foreign governments and sovereign wealth funds. Those are all entities that cannot sell without mortally wounding themselves because they have to meet underlying income requirements. And U.S. government bonds allow them a measure of security in doing that.

If you’re one of millions thinking that “things could be different this time” I don’t blame you. But, here too, think again.

Where are they going to put all that money if they do sell? Europe? Nope. China? Hardly. Japan? I don’t think so. There’s simply not enough liquidity anywhere to absorb a massive bond dumping bonanza.

And, finally, the Fed has been telegraphing that it’s going to raise rates at a “measured” pace which says to me that it’s going to be the slowest normalization in recorded history.
We’re probably talking about a few basis points at a time…at most. A basis point is bond speak for 1/100th of 1% so 25 basis points is 0.25%, for example.

I realize that’s hard to understand if you’re not used to dealing with bonds, so let me flip that logic around.

Imagine you have a bond portfolio that’s got a fairly typical duration of 5.6 years right now. Bonds, ETFs, funds… it really doesn’t matter what the composition is.

To have a 20% loss on your money, you’d have to see rates rise by 4% instantly. A loss of 10% would translate into a 2% hike overnight. There’s a snowball’s chance in hell that Yellen has that kind of moxy.

My point is that the nightmare scenario being advanced at the moment is very unlikely. Instead, it’s the product of some overly active imaginations and too much Internet access. No doubt there will be some volatility, but that’s hardly unexpected.

Two Investments to Slash Your Risk from Rising Rates

Now that we have that out of the way, let’s talk about what this means for your money and how to position yourself to win as rates rise.

First, take a look at every bond investment you have. In particular, you want to look for something called “duration.” That’s the number showing how long, in years, it will take for the price of a bond to be repaid by the cash flow it creates.

The shorter your duration, the less risk you have to an interest rate hike and the less volatile your bond portfolio will be.

Various studies suggest that having a duration of five years or less may remove 70% of the volatility from your portfolio yet still allow you to capture 90% of total bond returns over longer periods of time.

Second, if you’ve got munis or muni funds, make sure you think locally, not nationally. You want a good mix here because munis represent about 10% of the U.S. bond market.

Where most investors get into trouble is that they either inadvertently or deliberately wind up using them for around 90% of their bond portfolio. So they take on risk that will bite them in the financial behind when they least expect it. Anything more than about 30% is too much (but check with your financial advisor to be sure).

And, third, rethink owing individual bonds. Funds are better for most individual investors because they can be diversified, shed risk, and continually move up the coupon ladder as rates rise. Individual bonds have to be bought and sold which can be time consuming and risky, especially when you have to duke it out with bond professionals worried about the same thing.

If you don’t yet own bonds or want to begin rotating out of longer term bonds funds (with longer durations), now’s a great time to make your move.

Here are two choices to get you started:

  1. The Vanguard Short-Term Bond Index Admiral Shares (VBIRX), which has an effective duration of 2.7 years and a long history of solid performance.
  2. The Janus Short Term Bond (JSHNX), which also offers a potentially much smoother ride that longer term bond funds in its peer group. It, too, has low expenses and a long history of solid performance.

Like anything we talk about, the key is moderation. As rates rise, you will want to gradually increase your duration… and we’ll talk the best way to do that another time.

Until then,

Keith

33 Responses to What You Really Need to Know to Play Rising Rates (and Win)

  1. Polo says:

    I have vscgx vanguard life style conservative, which it has been taking some good daily losses; do you believe that this is a keeper?

    I am literally loosing thousands per day, except for this past Wednesday and Thursday gains. Today’s losses I won’t know for about another hour. I am seriously considering parking chunks in a few stocks like: Apple, Costco, target, IBM and Microsoft.

    Apple has taken some losses lately which make it very attractive. I own Apple now… Buying more tomorrow.

    I like your perspective and common sense approach to the bond market, your article was much appreciated.

    • Keith says:

      Thanks for the kind words, Polo.

      No doubt this is going to involve some pain for a lot of people on the bond front. Sorry you’re getting hammered – that stinks! Unfortunately, I cannot advise you personally because I don’t know your individual circumstances so it would be terribly inappropriate for me to do so. Not to mention, illegal.

      My suggestion is to take a look at the >>>ultimate<<<trailing stop and your respective allocations. If you're losing sleep or uncomfortable (never mind the money), that it's time for some changes.

      Take a good look at the 50-40-10 portfolio that's part of the Money Map Report because the structure may be of help.

      Best regards and thanks for being part of the Total Wealth Family, Keith πŸ™‚

  2. Barton NeVille says:

    Very logical and informative. Thank you.

  3. Tom Stanley says:

    If there is are companies that aren’t prepared for rate increases, well they must just be prepared to fail then.
    Rate increases and decreases are a fact of a financial life and those up and downs must be expected.
    For some people it is a new thing but many of us have been through it before – more than once.

    • Keith says:

      Well said, Tom.

      People forget that capitalism, by its very definition, includes success and failure. The road to prosperity is paved with the bones of companies that didn’t make it for whatever reason.

      Best regards and thanks for being part of the Total Wealth Family, Keith πŸ™‚

  4. yngso says:

    You told us about the rather obvious point that rate rises will be small and incremental, but which doesn’t get talked about much. Therefore, market volatility caused by traders’ psychological reactions will be temporary because the real economy will be improving?

    • yngso says:

      Sorry, that didn’t sound right. It does get talked about, that increases will be small and incremental. However, market psychology seems to react only to the direction, at least in the short term.
      I didn’t mean to say that Keith was talking about something that’s too obvious – au contraire – that’s something that SHOULD be obvious, because it gets talked about all the time…

      • Keith says:

        No worries. You are spot on.

        This market is all about psychology at the moment which is why logic often prevails. I know that’s counter-intuitive, but it’s all too real which is, in large part, why I wrote this column.

        Best regards and thanks for being part of the Total Wealth Family, Keith πŸ™‚

  5. Hilda A. Highfill says:

    Thanks for your piece on buying bonds now. Question: Most of us will not have access to Vanguard’s Admiral shares.
    Do you have another Vanguard bond ETF or fund to suggest? For ex., I have VCSH; is that comparable?
    Second question: I take it you prefer MF to ETFs. Am I right and if so why.
    Thank you.
    hah

    • Keith says:

      Hi Hilda. You’re welcome.

      To your question, VCSH is a short term corporate bond fund and, as such, more exposed to the corporate interest rate environment rather than the U.S. government market. While the two can act similarly under a wide variety of market conditions, that’s not always the case.

      As for mutual funds versus ETFs, either works depending on your personal preference when it comes to bonds which can be trickier to price than equities. I’ll gin up an article about this down the line. Thanks for the idea!

      Best regards and thanks for being part of the Total Wealth Family, Keith πŸ™‚

  6. george says:

    more a question … what % of your portfolio are you suggesting be of these short term bonds

    • Keith says:

      Hi George.

      Unfortunately, I have no context with regard to your personal situation so that’s a better question for your financial professional.

      Best regards and thanks for being part of the Total Wealth Family, Keith πŸ™‚

  7. Geraldina says:

    Thanks Keith for this in depth explanation of bonds. Yes, my folio advisor has consistently advised me of not owning bonds in my IRA. I don’t know very much about bonds so I followed his advise.
    Your article helped me a great deal to understand a little about bonds.
    Are these two funds good to have in an IRA? I am retired.

    Thanks Keith.

    Geraldina

    • Keith says:

      Hello Geraldina and thanks for asking.

      As much as I would like to answer that, I don’t know your personal situation so it would be inappropriate for me to do so. If your folio adviser is telling you that, I’d want to know why. There may be a good reason or reasons.

      For example, putting munis in a tax deferred account doesn’t make much sense because the tax exempt benefits of those holdings get lost. Further, withdrawals are treated as taxable income which means that you could potentially have to pay taxes on income that was produced tax free.

      Definitely ask.

      Best regards and thanks for being part of the Total Wealth Family, Keith πŸ™‚

  8. Ben says:

    What you think of HUSI.PD or HUSI/PD. I have heard they were good because the payout is pegged to rise much easier than most as rates increase. Can you comment on this?

    • Keith says:

      Hello Ben.

      This is a preferred stock fund with a floating rate which means, generally speaking, that it got higher yield potential and higher risk than bonds yet less opportunity for capital appreciation than stocks. Like bonds, these have an income that’s based on a percentage of par for the underlying holdings. Unfortunately, there is no single answer to your question because they’re subject to both rate changes and the underlying credit risk of the issuers in the portfolio.

      Best regards and thanks for being part of the Total Wealth Family, Keith πŸ™‚

  9. Luis Sousa says:

    I agree.
    However some investors can only hold gov bonds and some top supras and agencies, not basket of bonds.
    That beeing in US or european bonds.

  10. Tim Moore says:

    Greetings Keith,

    I see from the EKSO website that they will not post a rebuttal to the “Stomper” as they led you to believe. This is really not the greatest thing in my opinion. We have invested in this company and I still have faith in it but to tell you they were posting a rebuttal on their website and then let time erode and try to avoid the rebuttal is not to assuring that something is not wrong.

    Tim Moore

    • Keith says:

      Hi Tim.

      While I see your point, I also see theirs. Subsequent to our conversation, it appears that counsel advised that it’s best not to engage guys like the pumper because it eggs them on. Still, I’m keeping a close eye on the situation.

      Best regards and thanks for being part of the Total Wealth Family, Keith πŸ™‚

  11. gary ross says:

    It appears that the vanguard short term bond fund can only be purchased by institutional investors, at through Schwab, which is where I have my accounts. Are you aware of this? if so, why would you reccommend this bond fund to an individual investor such as myself?

  12. John R Stockhausen says:

    RE: Keith, First, I really would like to thank you for ALL the information you send me. It is really appreciated more than you know.
    Now, about your Email on what to do about (Raising Interest Rates) on Bonds, you gave me (2) Mutual Funds to use.
    Keith, may I ask you a question on these investments, is there any (ETF) that might work as good or better than Mutual Funds???? Keith, if we use the Mutual Funds you mentioned, (Most important is WHEN do we get into these Funds)????
    Thanks so much for everything.
    Sincerely Yours, John

    • Keith says:

      Hello John. You’re welcome and I really appreciate the kind words.

      With regard to when…I’m never a fan of market timing but there’s a reason. Studies show that having the right “structure” can account for 70-90% of total returns over time. Ergo, if you get that right, timing really isn’t an issue because you’ll have the flexibility to move in more measured steps. Like a surfer reading the waves, you’ll know when to ride and when to head for the beach.

      My suggestion is that you take a hard look at the 50-40-10 I’ve outlined as part of the Money Map Report. It covers a lot of what you’ve asked. I’ll also prep an article in the weeks ahead to highlight this.

      As for ETFs versus mutual funds…that depends on your preference and what you’re trying to accomplish.

      Best regards and thanks for being part of the Total Wealth Family, Keith πŸ™‚

  13. John R Stockhausen says:

    RE: Keith, When the next (Market Crash) comes, is there any way possible you could give me any Inverse ETFs so I don’t lose my pants???? If there is more than one could you “Please” send me what ever ETFs could be used????
    Again, Thanks so much for all you do for us.
    Sincerely Yours, John

    • Keith says:

      Hi John.

      Regarding the inverse funds, the easiest place to start for most investors is a fund like the RYURX or a single geared ETF like the SH. Generally speaking, stay away from the leveraged products unless you have a very short time frame.

      Again, get your structure right first. That way you’ll know whether an inverse S&P 500 fund is appropriate or, for example, whether an inverse Nasdaq might be more appropriate if you have tech investments to protect.

      Depending on your background and circumstances, you may also wish to consider put options and even futures contracts as effective alternatives, too. As is the case with every investment, these have unique characteristics and risks so do your homework first.

      Best regards and thanks for being part of the Total Wealth Family, Keith πŸ™‚

    • alice says:

      I DO NOT TRUST bonds, in any shape or form, long term, mid-term, short term, mutual fund or ETF, or single bonds, muni or taxable.
      Buying BONDS is same as LENDING MONEY. BUYING STOCKS, is same as OWNING SOMETHING. ASK yourself, do you want to LEND money? or do you want to OWN something?
      I would rather own than lend, especially this time. I am not sure getting paid back. Government is bankrupt, corporations are bankrupt
      individual businesses are not making real profit and most of them will go bankrupt in the long run. Why LEND money to them?

  14. Fallingman says:

    Who says the Fed is gonna raise rates or that the market will take long rates up?

    It’s all bluff and bluster. The economy is sick.

  15. ruth says:

    Hi Keith,

    Thanks so much for all your good advice, and education. This is wonderful and
    encouraging.
    Schwab cannot get VWELX – (unobtainable to newcomers) and also cannot get
    CPFXX. Could you provide an alternative for the former and info on possibilities
    of obtaining the latter and the quantity to get – if available..
    Also: ABBVIE is no longer on the list – should this be sold?
    I thought KTOS had to be sold, because it is not on the list – alas!!
    Best regards.

  16. fred says:

    Keith,
    Thanks for the good advice.You say that from 2000 to 2012 the s an p increased by only about 12%,which is true, but since then there has been a substantial increase .You omitted the performance from 2012 to 2015 June.

  17. ruth (rootenberg) says:

    Hi Keith,
    Thanks so much for all your good advice and education it’s wonderful and encouraging.
    VWELX (for the basic 50 of the pyramid) is no longer obtainable and Schwab also
    also cannot obtain CPFXX. Would you please, if permitted, provide alternatives for both and/or
    tell me where to buy the latter.
    There is a small 4 in the required field. What else is wrong?

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