One of the most common beliefs about investing is that a mix of stocks and bonds can provide the necessary diversification to earn solid returns while avoiding excessive risk. Most investors see bonds as the safer half of that mix, with stock prices having a reputation for volatility while bonds offer predictable streams of income over time.
Yet in recent months, even as the Dow Jones Industrials (DJINDICES:^DJI) have kept pushing higher, bond investors have seen firsthand just how disastrous it can be when there are massive fluctuations in a rising-rate environment. Fortunately, there are ways to address the issue. But first, let's look at how big a problem this can be.
How small rate moves can create big bond losses
At first glance, the moves in the bond market don't seem like a huge deal to the casual observer. For instance, 10-year Treasury bond rates have risen from 1.7% in early February to about 2.3% today. The 30-year Treasury has risen just slightly more, from 2.25% to roughly 3% over the same time frame.
Yet even changes of less than a percentage point can create big losses for investors. The iShares 20+ Year Treasury ETF (NASDAQ:TLT) has lost more than 13% of its value since the end of January, illustrating the danger of long-term bond funds in a rate environment like this. Shorter-term funds haven't been hit as hard, but even the broad-based Vanguard Total Bond Market ETF (NASDAQ:BND) has fallen 3% over the past few months, as has the inflation-protected iShares TIPS Bond ETF (NYSEMKT:TIP).
If you own bonds in the expectation of no losses, then these negative returns pose a real problem. Add to those losses the fact that bonds bearing low rates pay little income to investors, and even a modest 3% loss could take you one or two years to earn back in interest.
How to protect yourself
If you really want a fixed-income asset that won't lose any value, a bank savings or money market account is the best bet right now. The top-yielding banks pay about 1%, which isn't much but is still more than comparable Treasuries with maturities as long as three years pay right now.
One tempting place to look these days is in the high-yield corporate market, where so-called junk bonds have held up much better than most of their peers elsewhere in the credit markets. The reason: Junk bonds typically trade more in line with stocks than other bonds, as their weak credit quality relies on the success of the business over the long run. They might not fall like other bonds due to rising rates, but junk bonds often lose value if stocks drop. That doesn't offer the diversification protection you really want.
If you want to keep owning traditional bonds, consider reducing the duration of the bonds and bond funds in which you invest. By sticking with shorter-term bonds, you'll reduce your capital losses in a rising-rate environment. For instance, the Vanguard Short-Term Bond ETF (NYSEMKT:BSV) is down just half a percent from early February, much less than longer-term funds.
Asset allocation strategies can help you control risk, but you first must identify the actual risks. Counting on bonds to deliver reliable returns in a rising-rate environment could get you into a lot of trouble, and it's smarter to consider other ways of reducing overall volatility in order to manage risk better and to get the stability you want in your portfolio.