Wednesday, November 27, 2013

Curiouser and Curiouser

As Alice said so long ago, "It would be so nice if something would make sense for a change."

As the economy continues to strengthen, the bond market continues to weaken. Stocks want good news, while bonds want bad news. A bad economy implies continued Fed intervention, continued Fed intervention implies continued support for bond prices. 

But what happens when bond prices begin to fall in earnest? At some point, the economy will be unquestionably strong and the Fed will undoubtedly step back from its bond-buying smorgasbord.

What is a retiree to do when faced with absolute income needs yet also faced with the absolute certainty that bond prices will fall when interest rates rise? One solution is to buy the shortest maturity bond which produces the yield necessary for the retiree to continue his or her lifestyle. How else can a retiree lessen his or her bond portfolio volatility? The next step after limiting the maturity of the portfolio is to increase the coupon size of the purchased bonds. All thing being equal, the 7% coupon at a 5% yield will be quite a bit less sensitive than a 4% coupon at a 5% yield. 

What about those discount bonds that are held in the portfolio? One alternative is to swap them for high coupon bonds. There are ways to protect oneself as we move into the higher interest rate environment we all expect. Be proactive, seek out competent bond managers, and ride the rising rate environment with much less stress than those who choose to do nothing.

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