The headlines for most of the year have been about new all-time highs for the Dow Jones Industrial Average and the S&P 500.
For investors heavily weighted toward equities, a glimpse at the higher ending balance coming out of May masks other troubling phenomena in the markets. As the U.S. equity markets rose in May, the environment for those seeking income was changing quickly.
On May 1, the benchmark 10-year Treasury bond was yielding 1.66 percent. This rate was at the low end of an already historically low range for bonds and is the result of Federal Reserve intervention to stimulate the economy.
After years of programs designed to buy long-term bonds and lower interest rates, the conversation has turned to how the Fed might end its bond buying programs and let the economy rely on its own fundamentals.
Just as the bond buying program has been unprecedented, so will the exit strategy – and that is what has investors spooked. In late May, Federal Reserve Chairman Bernanke indicated that the Fed may begin to taper its bond purchases in its next few meetings. After those comments, what had begun as a slow rise in interest rates at the beginning of the month quickly turned into the worst month for Treasuries since 2009, according to Bloomberg.
By May 31, the 10-year Treasury yield had jumped to 2.16 percent. As bond prices move in the opposite direction of yields, this meant a quick decline in the value of many bond portfolios. The Vanguard Long Term Corporate Bond Index (VLCIX) declined 5.68 percent and the PIMCO Total Return Fund (PTTRX) dropped 2.47 percent in May.
There also was spillover into other yield-producing investments such as dividend stocks and Master Limited Partnerships. The Vanguard High Divided ETF (VYM) fell 2.65 percent and the Alerian MLP Index (AMZ) fell 5.34 percent from their multiyear peaks in the last week of the month after Bernanke spoke.
After years of receiving inflows from investors seeking safety and income, bonds and higher dividend equities now find themselves trailing the broader S&P 500 index year to date, and it raises the question of whether there is more downside.
The answer is going to be unpredictable, and it underscores the need for income-oriented investors to be careful where and how they reach for yield. For example, shorter term bonds typically fared better in May while more perpetual yield instruments such as MLPs and preferred stock were harder hit.
There has been much discussion of what happens when the Fed finally raises interest rates, but the past month has shown that mere commentary or “jawboning” from the Fed can have a significant impact on a portfolio.
For investors who have been relying on the principal protection capabilities of a bond portfolio, it would be worth delving a little deeper into the construction of that portfolio. Ask the following questions about how you are achieving your yield:
• What is the duration of my bond portfolio? Duration measures how much the value of your bonds will be affected by moves in interest rates. A shorter duration would mean less volatility.
• What is the overall credit quality of my income portfolio? Do I own low-quality bonds and stocks just to reach a yield target?
• What do I need more: Income or principal protection? In this environment, it may be difficult to achieve both in the short term.
The movement in interest rates upward may not happen in a straight line and it will certainly involve surprises driven by the market and policy makers. The key for investors is to understand that owning bonds is not without risk and the reach for yield can be perilous if it is not balanced against your individual goals.
Taking the time to understand your income portfolio can help you determine whether May was a tolerable event or a reason to re-evaluate your strategy.
Dennis Morton Jr., CFP, a partner and financial consultant with Concannon Wealth Management in Bethlehem, oversees the financial affairs of business owners, executives and families in the region. His practice areas include portfolio management, financial planning, estate planning and insurance. He can be reached at firstname.lastname@example.org.