23 Jul

Now Bonds are the “Problem” Area. What Should I Do to Protect My Portfolio?

July 23, 2013

October 10th is my wife’s birthday. One birthday in particular will always stand out in my mind: October 10th, 2007. You see, this was the day the stock market took an extreme plunge, leading us into the dark period of ’07-’09. At the end of that very long day, I waited in line at a flower shop to get my wife a bouquet of flowers. I can still recall the question I was asking myself (in somewhat of a cold sweat): “Should I really spend money on flowers after I watched not only my clients’ accounts, but also my own retirement accounts, fall so dramatically in one day?”

What happened then and now?
It was an interesting time to be in my profession. My clients were worried (and rightly so) about the rapid drop in the size of their portfolios. Do you know what I told them at the time? I explained that academic studies showed that the best way to weather such a market was to ride it out. After reviewing multiple academic studies on every conceivable angle of investing, our portfolios are totally designed using a best-of approach. Looking back, the bounce we got after the market started self-correcting was exactly as predicted.

Today, with the market hitting new highs, that time period seems like both a recent and distant memory. The “recent” part is in regards my clients’ worries about the other part of their portfolio-bonds. They fear that rising interest rates, in our current record-setting low interest rate environment, will cause the value of their bonds to deteriorate. I just read an article that obtained multiple opinions from bond experts; in fact, one expert went so far as to run simulations testing different bond strategies. The general consensus they came to was that you should “stay the course” with bonds-over the long term, any reactionary movement to avoid short-term volatility really doesn’t help you. Sounds familiar, doesn’t it?

What does this mean for bond holders?
As we know, on a year-to-date basis, pretty much every fixed income category has been down. Most of this reduction can be attributed to anticipation of higher interest rates, overreaction to Federal Reserve Chairman Ben Bernanke’s comments, and lower inflation expectations. However, we and many others see the reaction to Bernanke’s description of “tapering” as an overreaction.  With zero interest rate policy, the Fed has encouraged risk-taking globally by allowing investors to borrow funds at very low cost and use them to buy other higher-yielding assets.  His recent comments likely startled those who are stretching for returns into reducing their risk-taking for fear of a policy change.  The reality of the situation is that Bernanke was trying to distinguish between less accommodation and a tightening in policy (hike in interest rates), which, according to the Fed, still is not in the cards until mid-2015 at the earliest.

So what should I do to protect my portfolio?
Doing nothing is the correct course of action… when in doubt, ask your advisor. Bonds still bring value to portfolios when it comes to providing diversification and income.  A fixed-income portfolio is designed to provide a cushion when equities are suffering, a market-appropriate income, and a level of protection from inflation.  The portfolio maintains a good level of diversification from equity risk by avoiding high-yield corporates, and keeps its exposure to changes in interest rates (duration) on the shorter side (around 5 years) by largely avoiding long-term bonds. You can learn more about Savant’s bond strategy by reviewing our Savant Backstage paper, “The Fixed-Income Portfolio: A Three-Legged Stool.”

PS. My wife did get the flowers.

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