What asset classes were the leaders in 2013? Small cap stocks as represented by the Russell 2000 Index led the way with gains of 38.8%. Growth stocks did well posting gains of 34.2% as represented by the Russell 3000 Index. International stocks also reported double-digit gains (represented by MSCI EAFE NR USD Index), while bonds experienced net losses for the first time in a decade.
What are the expected winners for 2014? Probably not the winners of 2013.
That is why diversification in a portfolio among different asset classes is important. And this is why rebalancing your portfolio periodically is critical. Small cap is a higher risk asset class than large cap or bonds. The rush up in small cap in 2013 may have also increased your risk exposure. Rebalancing helps manage that risk.
Think of it as selling high – trimming gains off the best performers. And buying low – repositioning into assets that did not perform as well.
So what about Bonds?
Interest rates have been flat to non-existent for several years. Interest rates are expected to rise over the next few years.
Interest rates will rise as the Federal Reserve Bank continues to taper – or buy fewer treasuries each month. The Feds have a delicate balance to strike. Taper to fast and the constriction could slow the economy. Taper to slow and interest rates rise and we see increases in inflation.
While the Feds are doing their balancing act, the investor in bonds will have their own balancing act. Interest rates and bond prices have an inverse relationship. Bonds received the benefit as the interest rates were dropping, their bond prices were increasing. Now we will experience the reverse. As interest rates increase, bond prices will drop.
If you own individual bonds, selling your bond in an increasing interest rate environment will see a drop in your bond value. However, holding the bond until maturity and you will get the face amount of the bond. Holding steady may be your best course of action.
In a bond mutual fund, rarely are bonds held to full maturity. Money managers are moving bonds in and out of the portfolio. As interests rate rise, bonds are purchased with a higher coupon rate. In a bond mutual fund, your value will bounce around on rising interest rates, and hopefully your interest payment will increase.
However, in 2013, bonds experienced a year where loss in value was not completely offset with dividend/interest payments. This picture is not likely to change much in the next few years.
What does an investor do? This past year has seen an exodus from bonds to stocks. Do you hold bond funds or not? It depends. Much depends on your risk tolerance, age, and cash flow needs.
Bonds with shorter durations will have less value fluctuation with interest rate changes. The opposite is also true – bonds with longer maturity will see more price volatility with interest rate changes.
Lower credit quality bonds pay higher interest, as they have more risk of defaulting on payments. Since they have a higher interest rate, they will do better weathering interest rate changes.
Floating Rate Loans Funds have come into existence in the last decade, providing short term loans for corporations. They pay a little more than a money market account, but they also come with more credit risk.
Short duration bond funds have seen an influx of monies. These funds tend to have less credit risk and short durations. They are positioned to quickly respond to interest rate changes.
High yield bonds have weathered the impending interest rate changes better than most bond categories. They tend to have longer durations over 4 years. They pay a ‘high yield’ compared to other bonds because there is greater risk of defaulting on payments.
With the city of Detroit’s bankruptcy in the news, many investors are staying away from municipal bonds. Yet the default rate on municipals has declined over the last 3 years. If you are in a high tax bracket, you may want to consider this option as interest on municipal bonds is federally tax free.
Regardless of where new opportunities are to be found in 2014, investors should stay within their risk temperament. The pain of investment loss lives longer in our memories than the reward of investment gains. There is value in being able to sleep soundly at night.
Contact your financial advisor to help you navigate the risk and rewards of investing for 2014.
Securities and advisory services through KMS Financial Services, Inc.