Given the Fed’s latest interest rate hike, interest rates have been moving up. Thus, portfolios that contain long-term asset allocations are now experiencing more volatility and hence, a reallocation should be considered.
What would be a solution?
Excessive cash is not ideal because it just stays pat. On the other hand, bond allocation has the ability to rally when one needs it most - when the equity side of your portfolio is going down typically when equities are selling off. Assets such as intermediate bonds are still yielding more than cash. The yield curve has gotten flatter - no doubt about it - but there's still a little bit of steepness as you move from cash out to intermediate bonds in the 2-, 5-, 10-year range.
Of course, a common strategy that financial planners and investment advisors recommend to clients is the bond ladder.
A bond ladder is a series of bonds that mature at regular intervals, such as every three, six, nine or 12 months. As rates rise, each of these bonds is then reinvested at the new, higher rate.
Over the long term, higher rates are good for those that want to earn a higher return. Higher return does not come without risk so expect a transition period that inevitably brings volatility - in the terms of the bond market, some negative returns over the short term.
What is important to keep in mind is that bonds have both a price component and an income component. Thus, it is the income component that helps you recoup those short-term losses over time. One might get a short-term price hit as intermediate-bond yields move upwards, but then immediately keeps earning that coupon, and most probably will recover those losses over time (or hopes to).
As long as the time horizon is longer than the duration of your portfolio, short-term fluctuations in interest rates should not be alarming.
The target duration of a portfolio will really vary depending on the investor and their time horizon. Investors that have very short-term liquidity needs should probably invest in something like a money market or a very short-duration portfolio i.e. one to three years.
For most of us, the sweet spot is going to be what we call intermediate duration. That's a four-to-six-year-duration portfolio. It is long enough so that one gets to take advantage of the steeper yield curve, which typically prevails, and earns a little bit more income, but also gets that nice defensive posture that duration gives you against equities.
Moving any longer will introduce a lot more volatility. Thus, moving out into a 10- to 30-year maturity range, might be too much volatility for most investors, with the exception of some institutions that are trying to match their long liabilities with long-duration bonds.
Furthermore, history dictates that interest rates will not stay low forever, but the speed at which rates rise and how far up they climb is difficult to predict. Those who pay no attention to interest rates can miss out on valuable opportunities to profit in a rising rate environment.
This article was issued by Maria Fenech, Investment Manager Support Officer at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.