At last, the Federal Reserve has ended the Quantitative Easing program. This may have serious implications for fixed income investments and interest rates. Many investors believe that the Fed will increase short term interest rates in 2015 and because of that reason they no longer find fixed-income investments attractive.
The rates may or may not increase, but investors have to remain fully committed to the market. They also have to ensure that they don’t have too much interest rate risk or credit risk in their investment portfolio.
Short-term bond funds are an attractive investment option in uncertain investment climates, such as the one we are headed into. When you invest in high quality bond funds that have limited interest rate risk and credit risk, but you will like still enjoy attractive yields. As bond volatility correlates with maturity length, short term bonds are also less volatile.
Irrespective of the prevailing investing climate, at least a small portion of your assets have to be allocated to liquid investments that have reduced volatility. This will allow you to meet unexpected expenses in the event you need to sell something quickly. If you are trapped in an illiquid investment and a cash emergency arises, you may find yourself in a pickle.
Short term bond funds yield decent returns; however, they aren’t created equal. Some assume more risk than others. As it is not clear when the Fed will lift interest rates and what impact the increase will have on your portfolio as a whole, it is wise to review your bond fund portfolio to make sure that you fully understand the risks involved.
Short term bonds can produce attractive returns by investing in high quality bond funds diversified by industry, issuer and geography. While some bonds have lower interest rates and credit risk, others with floating rates can benefit if interest rates rise. Floaters manage the interest rate risk while at the same time offer a better yield. The investor has to be selective about yield curve positioning and duration. By rotating sectors and buying bonds selectively, an investor can gain greater returns.
One way of diversifying your credit risk is to invest in well-diversified corporate bond holdings. Even if the bonds are of high quality, an investor should not allocate more than 0.5% of their portfolio to one name. It is still possible to get high returns without having to dip into poor quality bonds. Bonds that offer a mix of high credit quality and attractive yields are the best.
There’s also taxes to think about. While some fixed-income strategies are taxable, others belong to tax-exempt categories. Investors who belong to higher income tax groups should consider investing in short-term municipal bonds. These funds offer significant tax benefits. Munis are often tax exempt at the federal level, and some are also exempt at the state level.
Uncertainty is the biggest nightmare of all investors; however, it also provides an opportunity to examine your portfolio. Now is the right time to analyze your short term bonds to understand their risks and to ensure that they will provide the kind of income, security and liquidity you need to meet your financial goals.
About Lawrence Meyers – Larry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at [email protected]