An improving economy will affect fixed-income investments. Revisiting your allocations can help prepare you for the risks and potential opportunities to come.
During 2008, as the stock market meltdown captured widespread attention, fixed-income investments were suffering their own quiet downturn. Sure, Treasury securities, whose backing by the U.S. government* makes them a reliable choice for mitigating risk, did relatively well. But virtually every other kind of bond suffered losses, with the lowest-quality bonds faring worst.
Despite the likelihood that a full-fledged economic recovery is still some way off, it may be time to look at how it could affect bond performance. Now that the biggest threats to the economy appear to have passed, investors willing to build more growth into their portfolios might consider looking at lower-quality fixed-income investments to provide them with the opportunity to capture more competitive yields than those available from U.S. Treasuries.
Inflation often rises when business and consumer activity picks up, and that could lead the Federal Reserve to increase the interest-rate targets it controls, although we do not think such action is imminent. Also, higher inflation reduces the value of interest income from bonds, and when newly issued bonds offer higher yields, existing bonds become less popular, depressing their prices. Moreover, some investors may have a greater appetite for risk in an improving economy, and that can benefit lower-rated bonds at the expense of higher-quality investments.
These shifts could affect your choices for a fixed-income portfolio. Cautious investors may continue to prefer Treasuries, but there appear to be good opportunities among higher-quality investment-grade bonds. And municipal bonds, another fixed-income option, may also deliver higher after-tax yields than comparable Treasuries offer. However, income for some investors may be subject to the federal Alternative Minimum Tax (AMT). Five-year municipals rated AAA** traded in mid-October 2009 at a yield of 1.9%, the equivalent of a taxable bond yielding 2.9% for someone in the 35% federal income tax bracket.***
Keep in mind that municipal bond investments call for a degree of caution. State and local governments that issue these bonds are under severe pressure in this recession, and if the economy worsens, default rates could rise. To offset the inherent risk in these securities, it’s important to seek out higher-quality munis that may have more secure revenue streams: general-obligation bonds, which are backed by the full taxing power of municipalities, and essential-service revenue bonds, which support such vital systems as water, sewer and power operations. Rather than allow such bonds to default, governments will typically raise taxes or take other steps to cover interest payments. Another defensive strategy is to diversify with a varied basket of munis.
Build America Bonds, a product of this year’s federal stimulus package, are attracting a great deal of attention. These bonds are obligations of the municipalities that issue them and aren’t guaranteed by the federal government. The interest they pay is fully taxable at the federal level. If you’re considering them, compare yields with those of other taxable bonds, and their after-tax yields with those of traditional tax-free municipals. For most investors, tax-exempt municipal bonds may be a better value.
Corporate bonds represent another area where an increased yield may justify increased risk. Many higher-quality investment-grade corporate bonds with intermediate-term maturities now yield more than 5.0%. That could be attractive as long as the issuer is a solid company and the bonds carry a strong investment-grade rating. Be cautious, though, about devoting a high allocation to corporate bonds that are rated below investment grade. If the economy remains in recession, shakier bonds could suffer from rising default rates.
Keep in mind that an improving economy, with rising inflation and interest rates, could hurt the value of all kinds of fixed-income investments. Bond laddering can provide needed flexibility. This strategy involves an investment in Treasuries, municipals, corporates or CDs with staggered maturities of, say, one, three and five years. When one bond matures, you can use the proceeds to buy another at the long end of the maturity spectrum. The strategy allows for greater diversification as well as the opportunity to reinvest at higher rates if yields rise.
Another way to prepare for higher interest rates and accelerating inflation might be to hold Treasury Inflation-Protected Securities (TIPS). Like most other bonds, TIPS pay a fixed coupon rate—the nominal yield if the bond is held to maturity—but if the consumer price index rises, the principal amount of the securities also adjusts upward, increasing the amount of interest investors can receive. For instance, if you invest $1,000 and inflation is 2%, the principal amount would be $1,020 at the end of the first year.
The fixed coupon on a five-year TIPS was recently 0.7%, about 1.7 percentage points less than the yield of a conventional five-year Treasury security. But if inflation rises at a rate of more than 1.7% annually during the next five years, the total return of the TIPS—including interest payments and increases in principal—would exceed the return on the conventional Treasury. There are tax consequences that you should be aware of for individual TIPS. You might also consider investing in the TIPS market through closed-end funds or exchange-traded funds.
There is no guarantee that inflation will rise soon, and experts disagree about the outlook. But by holding a diversified fixed-income portfolio that includes TIPS and other higher-quality bonds, you may be more prepared for whatever challenges—and opportunities—tomorrow’s markets present.
