David Fabian: Income investors face a brave new world in 2014 that is punctuated by real interest rates trending higher and the Federal Reserve slowly reducing the pace of their quantitative easing measures. This has led to fears of a massive shift in asset allocation from traditional fixed-income to equities and alternative investments. In fact, many have abandoned bonds altogether and have sworn off owning them for the foreseeable future. On the flip side, stalwart income seekers have shifted a tremendous amount of their holdings to short duration or credit sensitive holdings which have thrived in 2013.
The key to success in 2014 will be to strike a balance between credit, duration, and sector exposure to achieve positive returns in fixed-income. One thing that can’t be discounted is the level of income, diversification, and low volatility that is needed by retirees, pensions, and a host of other conservative investors. Bond’s shouldn’t be ignored, but rather implemented in a strategic manner to achieve your investment goals with the knowledge that there may be speed bumps along the way.
The following are some of my thoughts pertaining to opportunities and risks in bonds over the next 12 months.
Most investors perceive rising interest rates to be the biggest risk to bond holders over the next year. There are a number of ways that ETF investors can combat rising rates. One such method would be to purchase a rising rate fund such as the ProShares 20+ Year Short Treasury ETF (NYSEARCA:TBF). This fund essentially moves in the same direction as long-term interest rates and can hedge off a portion of the volatility in your fixed-income portfolio.
At this stage, it’s important to remember that interest rates have already risen considerably since their 2013 low. They will more than likely continue to meander through 2014 with a variety of ups and downs along the way. If you are planning on shorting treasury bonds, make sure that you do so with a risk management approach that takes into account the potential for deflation.
Another method of insulation would be to shorten your average portfolio duration. An example of which would be to move from the iShares Aggregate Bond ETF (NYSEARCA:AGG) to the Vanguard Short Duration Bond ETF (NYSEARCA:BSV). This would lower the effective maturity dates of the bonds in your portfolio, but also quite drastically reduce your monthly income stream. If you are dependent on the dividends from your investments, this strategy may eat into your capital over time.