For the past 30 years, beginning in the early 1980s, interest rates followed a long-term, downward trend. Declining interest rates are good for bondholders – as interest rates drop, bond prices rise.
Most economists predict that we are now entering a long period of rising bond rates, similar to the period from 1950 through 1980. Because rising rates tend to drive bond prices down, should we be dumping the bonds we own right now?
Â The short answer is no. An investor should always keep some allocation in a portfolio for bonds, both as a diversifier and as a source of income, especially for retirees. In fact, different bonds respond to rising rates in very different ways, so the types of bonds people choose will make a big difference in their returns.
What are the best kinds of bonds to own in an inflationary environment?
Â First, there are Treasury Inflation-Protected Securities (TIPS). Their prices adjust not only with changes in prevailing interest rates, but also based on the rate of inflation, as measured by the Consumer Price Index.
In a Federal Reserve Bank of Boston discussion paper in 2009, Michelle L. Barnes et al. wrote, “We conclude that, as is, the TIPS market provides a good hedge against inflation risk. … A ladder of TIPS, with maturities linked to when money is needed for expenses, would help investors in or near retirement hedge against their nominal expenses over time.”
Another good choice would be foreign bonds. Not only can investors find relatively safe bonds with current local interest rates that provide a higher return than those in the United States, but also currency-exchange rates often vary independently of bond interest rates, providing an additional boost to returns in U.S. dollars when inflation here is higher.
Even in this country, there are bonds that can increase in price despite rising interest rates. One example is convertible bonds, which contain a provision allowing the holder to convert the bonds into shares of company stock at a predetermined conversion ratio. The prices of such bonds can be correlated more closely with equity price movements than with interest rates.
Another example is mortgage-backed securities, packages of mortgages traded as securities. Notwithstanding their notoriety as one of the primary causes of the credit crash of 2008, many are currently priced at levels that do not reflect their true value.
“In our view, real values exist in this sector for investors with the expertise to conduct in-depth analysis at the loan level,” said Kathleen Gaffney, portfolio manager for Loomis, Sayles & Co.’s fixed income group and vice president for the group.
Investors should keep in mind that although rates are expected to rise over the long term, the path is far from smooth. There were many multiyear periods during the last rising-rate era when rates dropped, providing good return opportunities for bond investors.
In summary, not all bonds are created equal. Selecting the right types can assist people in keeping their portfolios diversified, regardless of what interest rates happen to be doing.