Interest rates and bond portfolios

As anyone who has recently refinanced a mortgage knows, interest rates are near historic lows. Low interest rates are good for borrowers, but not so good for lenders. This is important to remember because investors who buy and own bonds are lenders.

To help illuminate the risks and rewards of owning bonds, here are five key concepts that are worth keeping in mind.

Concept #1: Future interest rates are difficult to predict

Academic researchers have shown that movements in interest rates are difficult to predict. In fact, prestigious Wall Street economists have come up with widely differing interest rate forecasts when looking at the same information.

Current interest rates could remain low because of the weak economy, or they could rise because of Treasury actions, future inflation, or other factors. Any such increase could happen very gradually or quite suddenly. We don’t think it makes sense for long-term investors to position their fixed-income portfolios based on interest-rate forecasts.

Concept #2: Increases in interest rates hurt bond prices

This is part of the most fundamental equation of fixed-income investing. Rising rates make existing bonds less attractive, causing their prices to fall. The longer the maturity of the bonds, the more pronounced the effect. In other words, 30-year bonds will react much more negatively to rising rates than five-year bonds.

Concept #3: There is no free lunch.

Investors who are worried about increases in interest rates can buy three-month Treasury bills, which have a very low yield of 0.15%. These investors sacrifice yield for safety.

Those who seek higher fixed-income yields can either take more interest-rate risk (by buying longer-term bonds) or take more credit risk (by investing in corporate bonds instead of Treasuries).

Concept #4: Our bond choices are meant to reduce overall portfolio risk

Safety, not yield, is our top fixed-income priority. Our equity portfolio tilts toward value and small-cap stocks, which have returned more than growth and large-cap stocks over time. However, higher expected return is associated with higher volatility. Since the equity holdings in our portfolio can be more volatile than the Standard & Poor’s 500 Index, we want the bond side of our portfolio to be very safe.

That’s why we hold short-term and intermediate-term Treasury and agency securities. Short-term securities protect against inflation and intermediate-term bonds add incremental yield. In tax-deferred accounts, we also include Treasury Inflation Protected Securities (TIPS) for added inflation protection.

We avoid longer-term bonds, which have more interest rate risk, and corporate bonds, which have more credit risk.

Concept #5: Buy mutual funds, not individual bonds

We invest in bond funds instead of individual bonds. It’s true that investors can buy individual Treasuries and TIPS directly from the U.S. Treasury to avoid the expenses of mutual funds. However, we believe it’s worth paying bond funds’ relatively low expenses in order to gain their advantages: much greater diversification, greater liquidity, low transaction costs, professional management, convenience, and automatic reinvestment of interest.

Conclusion

We have carefully constructed the fixed-income part of our portfolios to provide what we believe is the right combination of stability, income, and inflation protection. We don’t believe it makes sense to change this composition based on unreliable interest rate forecasts.