Ready to bail on bonds? Not so fast
After last year's big party in the stock market, 2014 seems poised for continued improvement, or at least stability, across a number of dimensions.
Corporate and economic fundamentals are improving, and the housing market is steadily on the up and up—as is the labor market, absent this year's recent jobs report for the month of December. Meanwhile, inflation remains extremely low, below the Federal Reserve's comfort level of 2 percent per annum.
With more investors feeling better about the equity markets, redemptions from fixed income have accelerated and flowed into equity investments. Does this mean that fixed income is a thing of the past and only for the super-secure investors who are trying to avoid risk at any cost? Are those holding bonds fooled into thinking they are safe? Should investors sell out of their bonds before it's too late?
Not too quickly.
Although many pundits are calling for a huge fall in the value of bonds as a result of the anticipated rise in interest rates, investors need to understand how a potential rise in rates will affect the type of bonds they own and what the potential impact will be.
(Read more: Buckle up for likely bond-rate bump)
The value of a bond will fall as interest rates rise, because of the inverse relationship between its value and its yield (as the value of the bond falls, its yield will rise). The magnitude of such is reflected in the bond's "duration," which is a measurement based on its sensitivity to interest rates.
The bigger the duration number, the greater the interest-rate risk or reward for a change in bond prices. In general, a bond that matures in 10 years will have a duration of less than 10, and similarly, a bond that matures in five years will have a duration of less than five years.
It is a common misconception among investors that bonds and bond funds are risk-free. They are not. However, their standard deviation or measure of risk is far less than that of equities, so bonds do have a place in a diversified portfolio. Investors need to be aware of two main risks that can affect a bond's investment value: credit risk (default) and interest-rate risk (rate fluctuations). The duration indicator addresses the latter issue.
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During the 2008 recession and the ensuing years, bonds had been perceived as the safe "risk-off" trade for investors seeking security in their portfolios. In addition, the Fed had implemented its quantitative easing program, whereby it supported the bond market by buying some $85 billion worth of Treasurys and mortgage-backed bonds per month. That helped encourage investors to take some risk and invest in equities rather than receive the paltry yield in Treasurys, which as of early 2013 had been yielding 1.8 percent on the 10-year Treasury.
Coming off the heels of a strong equity market in 2013, the 10-year Treasury climbed to as high as 3 percent as the economy improved and investors sold off bonds. The value of bonds fell as their yield increased.
"Investors may want to shorten their duration so as to reduce the risk of loss to their bond values if and when rates rise."
But let's put this in perspective. As a result of this change in yield, core investment-grade bonds fell 2 percent—yes, 2 percent—their worst year since 1994. Remember, too, how equities fell some 40 percent in 2008?
Understanding that bonds had their worst year in two decades but fell 2 percent gives rise for a much-needed pause. Many analysts expect the yield to continue to rise in 2014 as the Federal Reserve reduces, or "tapers," its stimulus. But investors need to understand the benefit of having bonds in their portfolios as part of their asset allocation.
(Read more: Maximizing fixed-income investing with alternatives)
No one truly knows the velocity at which rates may rise or just how high they may go. In fact, although there are many macroeconomic positives that exist today relative to a year ago, we cannot ignore the fact that there remains uncertainty in the global economy. Witness the weak eurozone, with its structural imbalances; China's debt/infrastructure spending bubble; and Japan's test of Abenomics, the economic policy named after Prime Minister Shinzo Abe.
That's in addition to our own Fed monetary policy being far from normal, and the uncertainty as to how the Fed will exit from its zero federal funds–rate policy and unwind its huge balance sheet without economic or market shock. So although 2013 was a phenomenal year for the equity markets, the future is not a slam dunk.
Investors may want to shorten their duration so as to reduce the risk of loss to their bond values if and when rates rise.They may also want to diversify their fixed-income allocations among corporate and high-yield bonds and bank loans, all of which have different credit risks.
While both equity markets and corporate balance sheets have improved, these types of bonds have less default risk.They tend to perform better when interest rates rise, as compared to Treasurys, because interest rates rise typically when fundamentals look better.
Remember, too, that despite all the uncertainties that exist, as mentioned above, the U.S. is still regarded as "top notch" from a credit-risk perspective. There is stability in owning U.S. Treasurys. Knowing that there are myriad ways to manage the risk of rising interest rates, bailing on bonds altogether is not the answer.
—By Richard Coppa, Special to CNBC.com. A certified financial planner, Richard Coppa is managing director of Wealth Health LLC, based in Roseland, N.J.