In December 2013, we made a shift in bond funds that recently proved to be a very successful strategy. After the Federal Reserve meeting in September, another $10 billion was cut from the bond purchase program. This was done despite the continued commitment to keep short-term interest rates at zero. In October, it is expected the Fed will vote to completely end the bond purchase program. If the program does end long-term interest rates should rise.
Following the Fed’s September announcement, interest rates on the 10-year Treasury note (the benchmark for long-term interest rates) started to rise. With increased interest rates combined with a rising dollar, the stock market started to flounder and high risk bonds began to lose value.
There is an inverse relationship between bond prices and interest rates. When interest rates fall (as we have seen over the last 30 years) bond prices rise. On the other hand, when interest rates rise as we are seeing now, bond prices fall. This is the reason I made a dramatic change to the bond investments inside portfolios at the end of last year.
The technical term for a period in which short-term rates stay the same and long-term rates rise is referred to as a “bear steepener.” There is no way to know with any certainty how high rates will go, but I believe long-term rates will rise over the next 3-12 months before normalizing. During that time, high risk, high duration bonds will lose money. The only bonds that will have any chance during this time are low duration bonds.
A low duration bond is one that is short in maturity and has a high coupon rate and/or a high yield. The good news is at the end of December 2013 I shifted all bond funds in our portfolios to low duration bond funds. We were nine months early, but when it comes to shifts in the stock market, or in this case the bond market, it’s always better to be early than late.
Unfortunately most investors, advisors and even portfolio managers react well past these shifts. By that time it’s often too late and the losses have already occurred. While other comparable portfolios have seen considerable losses in their bond allocations since the Fed announcement, ours have been minimal.
I expect to maintain this low duration bond position for the present, especially with rumors circulating the Fed could begin raising short-term interest rates as early as next year. A rise in short-term rates may signal further adjustments in the portfolios. Regardless, I will continue to keep my finger on pulse of the Federal Reserve’s plans and the interest rate market to make certain the bond allocations inside the portfolios are properly invested.
Rest assured, I have been closely researching and studying the equity side of the portfolios throughout 2014. We are positioned where we need to be on bond allocation so that it is properly aligned as we head into our annual rebalance at year-end. Keep an eye open for future newsletters and video updates for my thoughts and plans on how I intend to fine tune the equity allocation of each portfolio.