So far in 2017, the U.S. economy has been showing signs of stronger economic growth ahead.
Since the presidential election, the bond market has flashed a signal of the expectation of stronger growth, higher future inflation and, thus, higher interest rates. Interest rates have soared with the yield on the 10-year U.S. Treasury bond going from 1.4 percent in June to around 2.3 percent now. Rates are still low by historical standards and will continue to bounce around; but it wouldn’t be a big surprise if the trend continues upward for a while.
Interest rates and bond values move in opposite directions; when one rises the other falls. When bond values fall, investors often wonder if they should hold on to their bond funds. The answer in most cases is yes. Discipline, patience and a willingness to diversify for the long-run are keys to investment success.
Bonds Play Key Diversification Role
Sometimes bonds get a bad rap, but they can play a key diversification role. Bonds historically have been a lot less volatile than stocks. In addition, bonds often move in the opposite direction as stocks. As a result, bonds have a calming effect on portfolio swings. Diversification does not eliminate risk, though bonds mitigate the bad times.
To put it another way, Marketwatch columnist Paul Merriman likens a portfolio to a car: Stocks are the engine, and bonds are the brakes.
Further, studies have shown that rising rates benefit investors over the long-term. Though higher rates temporarily weigh on bond prices, portfolios eventually benefit from the ability to reinvest at higher rates.
Bond funds hold perhaps hundreds of bonds, with bonds maturing pretty much all the time. Fund managers then put the cash into new bonds that pay higher yields. The income distributed to the investor eventually rises, and the investor can reinvest at higher rates – a rewarding strategy over time.