Even in a rising rate environment, a core allocation to fixed income still reduces overall risk in the portfolio and can provide reasonable returns.
With all of the headlines and attention given to Federal Reserve FOMC meetings, it may seem like the slightest increase in rates would spell disaster for bond holders. After all, when rates go up, then bond prices go down. However, not all bonds are created equal and not all rates are equally sensitive to the Fed Funds rate. Reviewing the last rising rate environment provides some perspective on what rising rates mean for a portfolio’s allocation to fixed income. The last time the Federal Reserve began raising the Federal Funds rate was at the end of June 2004, when they started at a rate of 1.0% and eventually reached 5.35% in July 2006. Between April 2004 and July 2006, the Barclays US Aggregate Bond Index returned 2.01% (annualized) with about half the risk of the S&P 500, which returned 7.43% (annualized).
We know that the Fed is going to raise rates. We do not know for sure when they will raise rates. Most analysts expect some movement by the end of year. That would be consistent with the expectation that the Federal Reserve is going to begin moving rates in about 6 months, which is the same 6 month expectation horizon that has persisted since early 2014. Reducing interest rate exposure in anticipation of Fed actions has not played out as well as many had expected. During 2014, the Barclays US Aggregate 1-3yr bond index returned 0.82% while the Barclays US Aggregate 3-5yr bond index returned 2.82%. This year through the end of May those same benchmarks have returned 0.76% and 1.72% respectively.
A rising rate environment will be more challenging for the bond market, but it does not spell the end to positive returns. Without knowing when the Fed will act, slightly reducing interest rate exposure during the short term will help to reduce the impact when they do begin to raise rates, but don’t overlook the value of maintaining a core allocation to a diversified bond portfolio over the long term.