Don't Panic Over Rising Interest Rates

Kiplinger

The scaredy-cats and fearmongers got it all wrong when they buried stocks and bonds after the Federal Reserve issued statements recently that suggested it might soon scale back its easy-money policy. I'm not shocked that interest rates on long-term U.S. bonds are higher now, at 2.6% for ten-year maturities, than they were in early May, when they yielded a full percentage point less. Bondholders, facing the prospect of miserly returns until 2023, sold once Fed members began making noises about ending the Fed's mammoth bond-buying program. For a few days, stocks, which hadn't had so much as a 5% pullback this year, went along for the downward ride. But both stocks and bonds quickly steadied.

See Also: Inflation Can't Get Off the Ground

It is true that some high-yielding stocks suffered an honest-to-goodness correction during the May-June turmoil. But the cause had more to do with their being overvalued than with anything the Fed implied it might do next. My favorable view of most high-yielding stock groups, including real estate trusts, energy-related master limited partnerships and assorted blue-chip companies, remains unchanged.

As for bonds, the run-up in yields is probably over for now. With inflation running a bit over 1%, real economic growth below 2% and unemployment above 7%, it's hard to see interest rates going much higher before the year is out. I think there's a good chance the yield on the ten-year Treasury could fall back to below 2.25%.

More turmoil ahead. All that said, the Fed's interest-rate-setting Open Market Committee meets again on September 17 and 18. Unless the Fed says afterward that low interest rates are here to stay, I predict that jittery traders will again unload stocks and bonds, creating an abundance of buying opportunities. Just wait three business days for the dumb money to finish its mischief before you start to snipe.

So are there any useful lessons from the latest Wall Street silliness? Of course.

First, you need to spread your money around in every asset category. "You would never not diversify your stocks," says George Rusnak, head of fixed-income strategy for Wells Fargo Wealth Management. "Well, the same definitely applies to bonds." Fortify your investment-grade corporates and municipals with a junk fund, a floating-rate bank-loan fund and a short-term bond fund. Use an unconstrained, or go-anywhere, fund as the core of your bond portfolio. On the cautious side is Osterweis Strategic Income (symbol OSTIX, yield 4.7%). More aggressive are Metropolitan West Unconstrained Bond (MWCRX, 3.0%) and Loomis Sayles Bond (LSBRX, 2.9%). The first two are members of the Kiplinger 25; the last is a member of the Kiplinger Income 25.

Second, the inefficiencies of the non-Treasury part of the bond market come into clear view during market panics. In the days after the Fed statement, for example, investors bailed out of tax-free funds at a feverish pace, forcing managers to unload perfectly good municipal bonds at fire-sale prices. Prices of some munis with coupons of 4% or more fell from 108 cents on the dollar to 100 cents in a matter of days, creating terrific opportunities for buyers (some investment-grade munis now yield more than 5% tax-free). But sellers got taken to the cleaners. If you own corporates or munis during these selling stampedes, you must stand pat until the rush dies down.

Third, bonds and high-yielding stocks have not yet reached a turning point that demands that you sell everything this instant. If you're worried about higher interest rates, shorten your bond maturities and rethink your stock holdings. But make your changes slowly. As always, sell into rallies and buy on dips. Let fools and day traders suffer for their mistakes.

Jeff Kosnett is a senior editor at Kiplinger's Personal Finance.

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