While some clients might want to bail out of bond funds amid interest rate hikes, they may also want to reevaluate why they have fixed-income products in their portfolios in the first place.

Depending on what their motivation is, they may or may not want to lighten up on fixed-income investments. Needless to say, paying close attention to market themes will be crucial in the near term.

There has been a general belief that, over the long haul, equities outperform fixed-income securities and cash. That’s the main premise behind most asset allocation models. Investors are taught that diversifying assets among and within equities, fixed-income investments, real assets and cash will be a benefit in the long run, and help soften the blow of a decline in any one investment. Given the general practice of over-allocating to equities, it may be surprising to know that, over the past 15 years, bond funds have outpaced their equity fund counterparts, with comparatively little volatility.

Granted, there has been an unprecedentedly long period of extremely low interest rates, when current yield and — perhaps more important — capital gains have played a big role in bond fund returns. Currently, however, the Federal Reserve doesn’t have a lot of room for more rate cuts in the future, with the effective federal funds rate hovering just around 0.34%. As a result, the capital gains potential for bonds going forward is relatively small.

Nonetheless, fixed-income securities might still have a place in client portfolios with their steady — but currently low — dividend payouts, given that global uncertainty is ever present, oil prices continue to be volatile and U.S. equity markets are posting one of their worst-ever starts to a year.

NORMALIZING INTEREST RATES

Until recently, fixed-income securities have been used to anchor portfolios, decreasing overall volatility and providing regular, recurring interest payments; capital gains, when realized, were just icing on the cake. Over the past few years, however, the Federal Reserve has let us know it is keen to normalize interest rates when the time is right. In 2014 the Fed abandoned its quantitative-easing program, and just this past December it raised its key lending rate for the first time in almost a decade.

The specter of rising interest rates has wreaked havoc in both the equity and fixed-income markets. Concerning the former, many investors feel that, if the Fed takes away the easy-money punch bowl and continues to raise rates, equities will fall. Some pundits believe the Fed’s very loose monetary policies, created in response to the Great Recession, caused equity asset inflation; they subscribe to the idea that historically low interest rates forced investors into risky assets, particularly equities, to beef up returns.

These pundits often give little recognition to improvements in the labor force, new technology advances and the spirit of entrepreneurism that accompanied low interest rates. Nonetheless, in reality, much of the available funds freed up by quantitative easing remained in banks, which were reeling from the financial crisis. Stricter lending and reserve requirements often kept the money on the sidelines and out of consumers’ pockets. So no one really knows what equities would have done in a less accommodative environment.

Fixed-income investors fear the decline in bond prices related to increases in yields. But interestingly, most of the Treasury yields have fallen this year, despite the Fed’s recent interest rate increase. The 10-year Treasury yield declined to 1.63% at its close on Feb. 11, after rocketing to 2.31% in late December following the Fed decision.

Investors’ flight to safety as a result of disappointing Chinese economic data, declining commodity values and a global equity market correction has put an incredible amount of downward pressure on Treasury yields; in the current environment, Treasuries provide not only a sense of safety for investors but also a more attractive yield than the bonds of most other advanced economies.

The new era of negative interest rates — recently introduced by the Bank of Japan — puts a twist on quantitative-easing policies. In prior QE schemes, the central banks’ focus was on increasing aggregate demand by lowering the cost of borrowing. But negative interest rates incentivize banks to make new loans — regardless of demand — or they suffer a penalty on excess reserves.

This may in fact trigger another round of unsound lending practices and set the scenario for the next crisis. In any case, the European Central Bank’s considering of another round of interest rate cuts, and possibly of a negative interest rate if the situation warrants, may counter Fed Chairwoman Janet Yellen’s goal to normalize rates.

RISKS TO GROWTH

During Yellen’s recent testimony to Congress, she acknowledged that she sees several risks to U.S. economic growth: the dollar continues to strengthen against its global brethren, stock prices have declined considerably so far in 2016 and borrowing costs are on the rise.

However, she also noted the improvement in the unemployment rate to 4.9%, that consumer spending remains steady and that the decline in oil prices might in fact help consumer spending. If the Fed does continue to raise interest rates in 2016, Yellen and team have repeatedly indicated it would be a slow and thoughtful process. So a rapid increase in interest rates is not in the cards — at least not yet.

This bodes well for fixed-income investors. Slow and measured increases in interest rates might offset weakening prices with resulting increases in yield. With fixed-income capital gains removed from the equation, at least to the magnitude we’ve seen in the past few years, we may not see bonds outperform their equity counterparts. However, select sectors may perform well and also provide stability to portfolios in a period when stock volatility is still high.

The large declines in oil and commodity prices have had a significant impact on some fixed-income instruments, causing investors to be more selective. Many high-yield bond fund investors were rattled by the news in December that the high-yield Third Avenue Focused Credit Fund was blocking investors from withdrawing their money. That raised investor awareness that there are liquidity issues in some sectors of the high-yield market, particularly for those corporations with large exposure to energy- and commodity-related issues.

BE MINDFUL

And, while there will be many opportunities in the bond market, advisors and their clients should be mindful that there still may be a few high-yield and investment-grade corporate bonds that are vulnerable to some of the same destructive themes witnessed in 2015: declines in the oil and commodity sectors, erratic growth and anemic corporate revenue. These factors could lead to possible future downgrades of those securities, meaning we should probably avoid them.

If a client’s sole purpose in owning a fixed-income security or fund is to benefit from capital gains or price appreciation, with little attention to yield, perhaps it is time to lighten up on bonds. While interest rate hikes might be on hold over the short run — discounting some catastrophic event or another financial meltdown — they are likely to rise, at least in the medium term.

If, however, one subscribes to the scenario that the financial markets will continue to struggle against a background of slowing global growth, combined with gradual increases in interest rates, and that market volatility will be a recurring theme in 2016, bailing on bonds may be a little premature.  

Buying higher-quality products — AAA- and AA-rated issues — and weeding out those high-yield and corporate investment-grade debt bonds that are on the verge of being downgraded because of their large exposures to energy and commodities could help dampen the volatility in a client’s overall portfolio.

While investors may miss out on some of the potential upswings by owning bonds in a well-diversified portfolio, the gut-wrenching feeling suffered if the stock market significantly declines should be mitigated at least slightly over the long haul.

Tom Roseen is a contributing writer for On Wall Street and the head of research services at Lipper.

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