For many years, fixed income investors reached for higher yields using risky investments, such as high-yield bonds, certain types of bond-like investments and high-dividend paying stocks.
Fixed income investments are vehicles with predictable return and the money is paid at certain times, such as monthly, quarterly or annually. Companies and governments issue bonds and pay a rate of return to raise capital. The higher the yield, or the income generated, the riskier the investment. There are different types of fixed income assets. Investors can buy individual bonds, or build a fixed-income portfolio using exchange-traded funds or fixed-income mutual funds.
With the Federal Reserve having raised interest rates four times in 2018 and possibly raising rates one to two times more this year, some of these investments are beginning to look unwise. Market watchers say safe investments like short-term U.S. Treasury bonds are starting to produce yields above 2 percent. For that reason, retirees with a fixed monthly income and other investors who have asset allocations tied to fixed income should reevaluate their riskier holdings.
Here's what investors should know about their fixed income investments.
Higher Interest Rates May Affect Fixed Income Returns
William Northey, senior investment director at U.S. Bank Wealth Management in Helena, Montana, says the risk facing fixed income investors is that the money they receive may be offset by losses, affecting their total return.
"The risk that you face is that the level of income, which is still relatively low, can be consumed on a periodic basis by the rise in interest rates," he says.
Jerry Paul, senior vice president of fixed income and portfolio manager at ICON Advisers in Denver, says previously popular investments like high-yield bonds and bank loan funds are suffering, since investors began pulling their money from these investments at the end of 2018.
The total return is down for two popular high-yield bond and bank loan ETFs: the iShares iBoxx $ High Yield Corporate Bond ETF ( HYG), which invests in junk bonds, and Invesco Senior Loan ETF ( BKLN), which invests in bank loans of companies with debt less than investment grade as well as bankrupt firms.
Paul says the losses in funds like these are a result of investors abandoning "the reckless pursuit of yield," which was popular before the Fed's interest rate hikes. When the federal funds rate was near zero, income-starved investors piled into high-yield and riskier credit vehicles seeking greater returns because the usual safe U.S. Treasury notes offered nearly no return.
Given the higher interest rate environment, Paul expects the spread to widen further.
Not only are yields changing, but there are also growing concerns about the credit worthiness of some issuers. Although the Fed has been raising rates for more than a year, the economic environment is different now as the overall outlook for growth has diminished, says James Barnes, director of fixed income at Pennsylvania-based financial services company Bryn Mawr Trust.
Investors Should Consider Adjusting Their Portfolios
With economic growth slowing, investors should consider trimming their portfolios' exposure to debt from companies with weak credit ratings, known as low-quality corporate debt, he says.
The credit spread between high-quality and low-quality companies is widening. Barnes says positive economic growth is decelerating, which could be problematic for the economy.
While Barnes doesn't expect economic concerns to be a worry until the end of 2019, he suggests "adjusting your portfolio today to lighten up on credit exposure."
Barnes says investors should stick with higher-quality corporate debt and consider some inflation-protected bonds, such as the Treasury's inflation-protected securities, known as TIPS. He says prices for TIPS look appealing because many investors assume inflation will run below 2 percent on an annualized basis.
[See: 7 Great Blogs for Investing Tips.]
"I think based on where current valuations are, inflation protection makes sense at the very least just for diversification purposes," he says.
Northey says he believes fixed income investors are better off changing their longer-dated investments for shorter-duration ones.
For instance, the two-year U.S. Treasury note yields about 2.5 percent compared to the 10-year U.S. Treasury note at 2.71 percent.
"You face much less interest-rate risk by owning that shorter maturity instrument at this point in time," he says.
Mark Heppenstall, chief investment officer at Penn Mutual Asset Management in suburban Philadelphia, says fixed income holders should also consider diversifying their allocations and adds that the short-end of the yield curve is currently more attractive.
"You don't want any one credit (issuer) or any one part of the credit market dominating," he says.
Experts say investors should stick with the high-quality debt, such as government-guaranteed mortgage-backed securities or U.S. Treasury bonds.
"We think TIPS are a great diversifier within a fixed income portfolio because they basically insulate you against increases in inflation and that is really the nemesis for fixed income returns," Heppenstall says.
More From US News & World Report