Why bonds belong in your portfolio

A common misconception about bonds is that they are a sleepy, low-return investment vehicle.

Nothing could be further from the truth. Despite this generalization, there are many products — such as high-yield, or junk, bonds and emerging markets bonds — that offer higher returns than the traditional core fixed-income products, like Treasurys, investment-grade corporates and municipals. These bond products have grown into legitimate and mature asset classes worthy of inclusion in many portfolios. Of course, these products come with greater risk than the core products.

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To be sure, bonds (fixed-income products) play an important role in any investment strategy, providing specific characteristics, such as predictable coupon/interest payments (usually fixed), fixed maturities and return of principal. These factors, in combination, are essential for effective financial planning and overall asset allocation. Additionally, and perhaps most importantly, bonds provide a necessary counterbalance, acting as a low-correlation asset to the higher-volatility equity portion of a portfolio.

There have been countless articles addressing the issue of owning and managing bond portfolios in a rising interest-rate environment. Here's the problem: One rate-hike scenario can differ greatly from another, depending on the underlying economic and market conditions driving the interest-rate policy at the time.

Traditionally, the motivating factors behind the Federal Reserve's decision to raise rates have been in response to high levels of inflation, dollar strength or unusual market behavior (bubbles) in order to achieve the Fed's mandate of full employment and low inflation. This time, however, things are different — as we are already essentially there. The present situation is a result of the post-financial crisis policies of zero interest rates, the unwinding of quantitative easing and the Fed's desire to "normalize interest rates."

In its effort to provide transparency and minimize extreme market reaction, the Fed continues to emphasize a "low and slow" path toward implementation of this goal.

"Even if the Fed were to gradually raise the Fed funds rate ... over the next 12 months, the impact on bond levels will likely be modest."

So what does all this mean for the bond investor, and what impact will this have on the bond markets?

Frankly, not much. With low energy prices, modest if any wage pressures and inconsistent economic growth both domestically and abroad, the prospects for increasing inflationary pressures appear rather muted.

Even if the Fed were to gradually raise the Fed funds rate from zero to 1 percent over the next 12 months, the impact on bond levels will likely be modest, with the most impact in the front end of the yield curve. In fact, there is the possibility that a rate hike in the current environment could produce more pressure on credit spreads, particularly in the more highly leveraged names.

Nobody has a crystal ball to predict the future, but experienced fixed-income professionals enjoy the benefit of historical perspective and understanding of how various markets might react to shifting parameters and events.

An increase in interest rates can reshape the yield curve, reduce new issue supply and increase financing costs for most issuers. It's obviously complicated. That's why only experienced market professionals have the tools in their toolbox to anticipate and respond tactically by employing opportunistic rebalancing strategies necessary to keep pace with constantly changing economic and market conditions.

— By Freddie Offenberg, partner and portfolio manager at Andres Capital Management

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