Conservative investors have probably been frustrated recently. The S&P 500 index of stocks returned a strong 3.70% in November. With a month left to go and the stock index up 9.79% for the year, it’s shaping up to be a good year for the stock market. The bond market—to which conservative investors have a higher exposure—has been another story.
Rising Rates Provide a Headwind for Fixed Income
A fundamental relationship exists between bond prices and interest rates. When one goes up, the other goes down, like a seesaw. After declining sharply for most of the year, interest rates are now higher than they were on January 1st. Rates began a slow and steady rebound in back in July, as investors shook off the concerns around global growth that sent markets south in January and February, as well as the Brexit shock in late June. The case for the Federal Reserve increasing interest rates in its December meeting has seemed increasingly strong for months. But the real movement in interest rates came on the heels of the surprise election result in the U.S. With Donald Trump’s victory came expectations of reduced taxes and increased fiscal spending, which led to expectations of higher inflation, which led to increasing interest rates. The yield on the 10-year Treasury Note rose 0.54% from 1.83% on October 31 to 3.27% by November 30. This is a big move, particularly considering that interest rates had already been rising off of their mid-year lows.
This phenomenon of a rising stock market and rising interest rates is a double-whammy for conservative investors, who tend to hold most, if not all of their portfolio in fixed income investments (like bonds.) This is especially true during the fourth quarter; the increase in rates has been so fast recently that the income provided by bonds over the same period of time has not been enough to compensate for the decreasing prices of those bonds. In other words, while the stock market was up nearly 4% in November, many bond-heavy portfolios lost money during the month.
Don’t Forsake Fixed Income
It may be tempting for conservative investors to shift to a heavier stock allocation. A sound economy and Trump’s agenda of fiscal stimulus suggest that stocks and interest rates may both continue to rise. However, fixed income is essential for diversification and reducing volatility in a portfolio. If you have been investing conservatively, chances are you have good reason to do so—maybe you are in or near retirement and regularly draw on your investments, or perhaps you don’t want the emotional stress of seeing your account lose significant amounts of money during bear markets. Your fixed income investments should provide more stability than stocks. Interest rates may very well continue to rise, but they cannot sustain the rate of increase that we’ve seen over the past month for very long. A slower increase should allow a positive total return for most fixed income investments*, due to the regular interest payments these investments provide. And though we can’t know when the stock market will go down again, we can be fairly certain it will. When this happens, conservative investors will be glad they held onto their bonds.
*A key factor to consider is the duration of a fixed income investment. Bonds with shorter duration have earlier maturity dates. For reasons that are beyond the scope of this blog, shorter duration bonds will do better than long duration bonds when interest rates increase.