Benefits of Bonds When Rates Are Rising

November 5, 2018

2 minute read

Interest rates have been moving up, and the good part of that is cash yields have been going up. What’s not great is to shift assets from your long-term asset allocation into cash. You should think about how much do I need to meet short-term liabilities? And the rest, you should continue to have in your traditional asset allocation.

There are a couple reasons why you want to stick with intermediate bonds over excessive amounts of cash. Number one, intermediate bonds are still yielding more than cash. The yield curve has gotten flatter—no doubt about it—but there’s still a little bit of steepness as you move from cash out to intermediate bonds in the 2-, 5-, 10-year range.

You can actually roll down that curve and get a little bit of capital appreciation on top of the income that you’re earning. But I actually think the best reason of all to stay with your intermediate-bond allocation is that bonds typically rally when equities are selling off.

Cash is not going to rally. It’s not going to go up in price. It’s not going to go down in price, it’s going to stay pat. But your bond allocation has the ability to rally when you need it most—when the equity side of your portfolio is going down.

Over the long term, higher rates are good for all of us who want to earn a higher return. But that transition period inevitably brings volatility. And in the terms of the bond market, some negative returns over the short term.

What’s important to keep in mind is that bonds have both a price component and an income component. And it’s the income component that helps you recoup those short-term losses over time. You might get a short-term price hit as intermediate-bond yields move upwards, but then you immediately keep earning that coupon, and you’re going to recover those losses over time.

As long as your time horizon is longer than the duration of your portfolio, you shouldn’t be bothered by short-term fluctuations in interest rates.

The target duration of a portfolio will really vary depending on the investor and their time horizon. Investors that have very short-term liquidity needs should probably be in something like a money market or a very short-duration portfolio—one to three years.

For most of us, the sweet spot is going to be what we call intermediate duration. That’s a four- to six-year- duration portfolio. It’s long enough so that you get to take advantage of the steeper yield curve, which typically prevails, and you get to earn a little bit more income, but also get that nice defensive posture that duration gives you against equities.

Moving any longer will introduce a lot more volatility. So moving out into a 10- to 30-year maturity range, that might be too much volatility for most investors, with the exception of some institutions that are trying to match their long liabilities with long-duration bonds.