With stimulus spending on the horizon, and US GDP set to ramp higher, the US Federal Reserve is set to hike interest rates three times in 2017. The US stock market has had an amazing run following the election of Donald Trump in November of 2016. Investors all over the country are looking at their portfolios and asking “why do I own bonds if US stocks are going to continue rising and the FED is raising interest rates?”
First, lets look at why bonds are in your portfolio in the first place. Bonds guarantee (unless the issuer defaults) an income stream plus return of you principal at the end of the bonds’ term. Because of these guarantees, bonds are considered much safer investments than stocks (stocks guarantee nothing). Bonds tend to have a low correlation to stocks over the last 100 years or so which means they are good for diversification purposes. Bonds also tend to rise in value when stocks are falling which means they may help cushion against a fall in stock prices. Bonds are considered “low risk, low reward” so by adding bonds to your portfolio you lower your expected return but you also lower your risk.
Back to the question: “why do I own bonds?” We hold “safe” bonds so that we are free to take risks with the other monies in our portfolio. Stocks are volatile. They go up and down at a moments notice and most of the time the moves make very little sense. But over time investors are rewarded for their risk taking via higher returns for stocks verses bonds. Because most people either cant or shouldn’t tolerate the volatility of a 100% stock portfolio, investors add bonds to smooth out the volatility over time. Stocks are what get us to our retirement goals, but bonds help us sleep at night while we are trying to reach those goals.
Yes the FED is set to hike interest rates this year and higher interest rates tend to mean lower bond prices in the short term. But investors often forget that the financial markets are a discounting mechanism, meaning that they price what they think will happen in the future into today’s prices. The bond market is currently “pricing in” three 25 bps interest rate hikes this year. This means that IF the FED hikes three times this year, the price of bonds should stay relatively steady because this “fact” is ALREADY reflected in the price of every bond today. Only a move contrary to what the market thinks it currently knows will cause a further move in prices: that would mean more than three rates hikes (bad for bonds) or less than three rate hikes (good for bonds) in 2017. To sum up: the market already “knows” the FED should hike rates this year and is priced accordingly.
So are bonds a bad investment right now? If you happen to know the future, then you know the answer. If you do not know the future, then you own bonds to offset the risks you are taking with the equities in your portfolio. The amount of bonds you own should be in line with your investment horizon and risk tolerance. Also remember to be wary when those on Wall Street are “certain” of something. Wall Street (and Main Street I would argue) is currently certain that stocks will keep rising and that bond prices will fall in the near term. Jeff Gundlach has a great quote that I am paraphrasing: “when those on Wall Street are certain of something, run the other way because that is the exact time that the opposite is about to happen”.
*The above article is informational in nature only and is not a recommendation to buy or sell securities. All information is gathered from sources believed to be reliable, but neither Charles Brown nor Ausdal Financial Partners, Inc guarantees the accuracy of the information. All investments carry a degree of risk. Individuals should consult with their tax and investment professionals before making changes to their investment portfolios.