For many small investors, rising interest rates look like a blessing wrapped around a curse. As the accelerating economy of the last year has pushed rates higher, that means the value of bonds they already own fall. Is the search for yield worth it, or fraught with new risks most retirees (or prospective retirees) don't really understand?
The problem is that rising rates mean that the value of the bond paying that interest declines, cutting into bond returns. Even though 10-year Treasurys are paying around a 3 percent yield, while 30-year bonds pay just under 3.2 percent, the Barclays Aggregate US Bond Index is up just 1.6 percent this year, in part because of principal losses.
If rates keep rising, that tension will only grow. The prevailing market wisdom — at least before the recent volatility in stocks and increasing concerns about a slowdown in the U.S. economy — had been that the Fed would hike as many as three times next year. The Fed is expected to raise rates again this month after its two-day meeting on Dec. 18-Dec. 19, with the market placing the odds of the increase at 78 percent as of last Friday. Many economists still expect three hikes next year as well.
But the interest rate situation is fluid. The weaker than expected nonfarm payroll number last Friday was read by some market experts as a sign that the Fed would be more patient with rate increases. Some also interpreted a recent speech by Fed chairman Jerome Powell as a sign that the Fed might slow down the pace of rate hikes — he said rates "remain just below the broad range of estimates of the level that would be neutral for the economy."
Powell is not the only Fed official who has recently been preaching patience.
Predicting the direction in interest rates is a tough business, and one basic fact won't change: Bonds traditionally are safer than stocks, while delivering lower returns. Chip Norton, managing director of Naples, Florida-based fixed-income asset manager Wasmer, Schroeder & Co., which manages roughly $9 billion for its clients, says nothing that pays a high yield is totally safe, and nothing that's totally safe pays a high yield. So bond strategists such as Norton say the trick for income investors when rates rise is to contain principal losses on bonds to bolster total returns.
The simplest way to control bond principal risk is simply to hold bonds to maturity. If a small investor is satisfied with the 3 percent interest that 10-year Treasurys are paying, and buys some, that income is fixed for the term of the bond. Since Treasurys, rated Aaa by Moody's Investor Service, are the closest thing to a bond with no risk of default, an investor who buys them at par value will get 100 percent of principal back when the bond matures, along with all the interest paid in between.
Fluctuations in the value of that bond as rates rise and fall have no impact on investors who hold the Treasurys but don't trade them, says Stephen Laipply, head of fixed-income strategy for the iShares ETF business at asset management giant BlackRock.
"If you hold the bond and there's no credit event [like a default], you'll collect at par," Laipply said. "If you hold to maturity, you will be fine.''
The next-best strategy is unfamiliar to many small investors — it's called "laddering."
Laddering describes building a portfolio of bonds or bond funds with different maturities, which avoids the risk of betting that any one specific borrower will repay its bonds in full. The idea is that owning bonds that mature in each of the next several years will balance the higher coupon on longer bonds with the lower risk of principal loss on the ones that mature sooner, producing the best mix of risk and reward.
The problem with this strategy is that it requires a big portfolio to buy enough bonds to diversify and ladder your money in a way to balance income needs and risk, said Mike Tucci, CEO of Lexington Wealth Management, a registered investment adviser firm in Lexington, Massachusetts. Many clients need at least $500,000 in bond assets alone to balance all the risks optimally, he said.
Many investors are turning to exchange-traded funds that make laddering easier, a market where ETF leaders Invesco and BlackRock are attracting the most assets.
The idea is that each fund specializes in a certain class of bonds, maturing in a certain year. Examples might include corporate bonds due in 2019, high-yield bonds due in 2022 or municipal bonds due in 2025. Laddering strategies can include bonds due as much as a decade into the future, and each fund can hold as many as several hundred bonds to hold down default risk from any one borrower.
The funds have pulled in about $4.9 billion in capital so far this year, said Sumit Roy, an analyst at ETF.com. Invesco, at $2.6 billion, has attracted a bit more than BlackRock's $2.3 billion. Most of that money has gone into funds focused on 2019, 2020 or 2021 maturities, rather than longer-term debt, according to the data.
The idea is for an investor to take the money from each set of bonds maturing and roll it into a longer maturity paying a higher rate, as other bonds move closer to maturity, Laipply said. Ideally, investors would hold each ETF until the 300 or so bonds in it mature, letting diversification manage any risk of defaults.
"If you do this, the total return will be enhanced,'' he said.
Invesco claims that shifting bond portfolios to laddered approaches can boost returns by up to 0.9 percentage points a year, depending on whether a client chooses corporate, high-yield or municipal bond funds.
Recent returns, however, haven't been stellar. Hampered by principal losses that show up in day-to-day prices, many laddered funds from both companies have one-year returns that are below their current yields, reflecting the stop-and-go sentiment about how quickly interest rates might rise.
Invesco's 2022 BulletShares Corporate Bond ETF, for example, has a 2.8 percent yield but has has lost 1 percent of its value this year, according to ETF Database. Its 2026 High Yield Corporate Bond ETF has lost 1.5 percent of its value despite a 5.3 percent yield, the database says. At Black Rock, the iBonds Dec 2022 Corporate ETF has lost about 1 percent of its value despite a 2.8 percent yield.
Principal loss is enough to intimidate a lot of small investors, said Mitchell Goldberg, president of investment advisory firm ClientFirst Strategy in Melville, New York. But focusing on short-term performance misses the point of choosing a laddering plan, he said. Much like individual bonds, laddered funds are designed to be held until the bonds in them mature. There needs to be a balance struck between the reality of the current bond market and the income needs of investors in retirement.
"They definitely should worry about loss of principal, and they should be invested in something that pay more than the rate of inflation," especially if they are relatively young retirees who need to make their nest egg last, Goldberg said. "People know so little about how to make the transition from growth to distribution of their assets.''
For his part, Tucci warned investors against just chasing yield. "Create a portfolio that makes sense," he said. "You can't get too carried away chasing any single goal.''
—By Tim Mullaney, special to CNBC.com