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Bond investors must adjust their expectations

The current bond market brings to mind that old ad campaign that stated: "This is not your father's Oldsmobile."

At the same time those TV ads ran in the 1980s, bond yields started their slow decline after paying interest rates as high as 15 percent to 20 percent. This created a lucrative outcome for bond investors: From 1981 to 2015, the broad bond market tracked by Ibbotson's SBBI Yearbook returned an annual average of 11.03 percent compared with 10.98 percent for the S&P 500 Index, an unmanaged basket of the largest U.S. stocks. Because of this, that period is now known as the 30-year bull bond market.

Before the 1980s, bonds were like the Oldsmobile of previous decades — relatively low-yielding but secure for conservative investors. But over the last 30 years, bonds began rewarding investors with income and capital appreciation, prompting a generation of investors to look at bonds in a whole new way.

Jin Lee | Bloomberg | Getty Images

Now, unbeknownst to many individual investors, interest-rate trends and economic dynamics suggest another transition that may entail more risk.

When interest rates fall, the value of existing bonds goes up and vice versa: Picture a teeter-totter with rates on one side and value on the other.

If you own a bond that pays 5 percent interest and overall interest rates fall to 4 percent, your bond is more valuable because investors can no longer get such a high yield. If you went to sell your $100 face-value bond, someone would happily buy it for, say, $102. Your total return on the bond at the end of a year would be that 5 percent interest plus the 2 percent you made in capital appreciation. This has been pretty much the norm for all types of bonds for prolonged periods over the last three decades.

Now interest rates appear to be on a gradual rise, though they are expected to remain low. The Federal Reserve has raised the federal funds rate by a quarter point already and is expected to raise interest rates in December by at least as much. As long as the economy stays relatively strong, rates may edge up.

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For investors, this means new bonds will pay more interest. But instead of capital appreciation on existing bonds, we may have the opposite — capital depreciation, at least to some small degree. The value of that $100 bond might fall to $99. At the end of the year, you would have collected 5 percent interest, but depreciation would have meant only a 4 percent return.

Although capital depreciation may not end up being a big factor, investors may want to rethink the place of bonds in their portfolios. Here's a few strategies for investors:

Reassess your asset allocation. Back in the heyday of the Olds Cutlass Supreme, financial planners commonly recommended that you subtract your age from 100 to get your portfolio allocation for stocks vs. bonds. If you were 60, went this logic, you should have 60 percent of your portfolio in bonds and 40 percent in stocks. Few planners would recommend this today, though many investors still have this allocation to bonds.

"One thing is virtually certain: If you invest in bonds today as your father did, it will be a twist on that old commercial — 'This is not your father's bond.'"

Keep durations short to neutral. The shorter the term, the less sensitive bonds are to interest-rate increases. Bonds with a duration of one year or less lose little value when interest rates increase. By contrast, values of long-term bonds, such as 30-year Treasurys, swing the most with interest-rate changes.

Focus on quality. For your fixed-income investments, stick with or move to government bonds, mortgage-backed securities and investment-grade corporate and municipal bonds, at least BBB- or higher, as rated by Standard & Poor's, or Baa3 or higher, as rated by Moody's.

Assemble a bond ladder. If you own bonds, one way to control fluctuation in price from interest-rate changes is a ladder concept. You buy individual bonds of varying durations but perhaps no more than about seven to 10 years (e.g., one, three, five and seven years). Then, as the bonds mature — say, one bond a year — you get periodic payouts of the money you invested and meanwhile collect the interest payment. Thus, you periodically take money off the table, lessening your exposure.

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Avoid international bonds. The top economies of the world are offering very low to negative rates, so there's not much allure for U.S. investors, where rates are higher already. And foreign bonds expose investors to currency risk — if the dollar falls against major currencies, your foreign bonds will generally decline in value.

Look at Treasury inflation-protected securities. These government bonds have two interest-rate components, one of which rises with inflation as measured by the Consumer Price Index. You can buy directly from the Treasury or through mutual funds and exchange-traded funds. But they don't pay as much interest as regular bonds. And when they're adjusted for inflation (twice annually), any increase on TIPS held directly is taxable income.

Unfortunately, there's no substitute for investment-grade corporate bonds or U.S. Treasurys to balance equities in a portfolio. Yet one thing is virtually certain: If you invest in bonds today as your father did, it will be a twist on that old commercial — "This is not your father's bond." From a returns perspective, they won't be powering your portfolio.

— By Trey Smith, private financial advisor at SunTrust Investment Services