Mantra for 2017: Be careful of bond risks

This is the time of year when investors like to tinker with their portfolios in an annual exercise known as rebalancing. The idea is to take some profits out of accounts that have performed well and redirect the proceeds into laggard investments. Rebalancing provides an opportunity to return a portfolio to your intended mix or allocation.

This year, as in most years, that means skimming some profits from stocks and stock funds and reinvesting them in bonds and bond funds. That's the usual scenario because equities typically outperform fixed-income investments. The pattern has held so far in 2016 too.

In this sense, rebalancing helps to dampen the riskiness of a portfolio.

"If you've been taking a hands-off approach to your portfolio — and that’s usually a pretty good strategy — its contents are likely to have shifted . . . stocks have likely grown in importance," noted Christine Benz of Morningstar in a recent commentary. "The net effect, especially of an enlarged stock position at the expense of bonds, is that your portfolio likely has more volatility than it did even a year ago." 

But the problem with rebalancing into bonds this time around is that bonds could be more treacherous than normal. The bond market weakness of the past month or so could be the beginning of a prolonged move, making it worrisome to divert a lot more money to fixed-income investments. Most people need some bonds for stability, and interest rate movements are difficult to predict anyway. But if rates continue to increase and inflation bubbles higher, bond prices could get clobbered.

Stocks also could get clobbered, but everyone knows that. Not all investors are aware that bonds and bond funds can be volatile, too. Bond prices move inversely with the general level of interest rates, so if rates commence on a sustained upward trajectory, prices will drop.

That's a fairly predictable mathematical relationship, unlike with stocks. Equity prices often appreciate even when rates are increasing, especially when yields are below 5 percent, as they clearly are now, noted Larry Puglia, a stock-fund manager at T. Rowe Price. Stocks can advance despite rising rates because rates often increase when the economy is strengthening and corporate profits reflating.

Interest rates have dropped — and bond prices have appreciated — for most of the past 35 or so years. The next major move, whenever it comes, almost certainly will be in the opposite direction.

Contrary to conventional wisdom, bonds actually fall more often than stocks if you focus on prices only and exclude stock dividends and bond interest payments. The reason stocks get such a bad rap is that their declines typically are much larger and much scarier. 

Excluding dividends, stocks of companies in the Standard & Poor's 500 index lost at least 20 percent of their value in six separate calendar years since the mid-1920s, according to data compiled by Morningstar/Ibbotson. That has never happened with government bonds. Hence the reason for holding bonds and bond funds in a stock-based portfolio: stability. Stock and bond prices historically have declined together only about one year in six.

But as noted, now could be the start of a precarious period for bonds. While stocks as measured by the S&P 500 are up about 9 percent so far this year through November, including dividends, the broad U.S. bond market is only about 2 percent higher, including interest income. Many types of bonds have lost ground in recent months on the assumption that economic growth and possibly inflation will perk up next year.

So if you are planning to rebalance by shifting money into bonds or bond funds, be careful — especially about securities with long maturities above 10 years or so. These are the fixed-income assets most vulnerable to rising rates.

But rebalancing is about more than simply adjusting your mix of stocks and stock funds compared to bonds and bond funds (though that's usually the most important decision). Here are some other general tips:

• Decide on a strategy. While some experts recommend balancing once a year — say around the end of December — you also could do it when your mix gets out of alignment by a certain amount. To use a simple example, suppose you aim to keep 60 percent of your portfolio in stocks and 40 percent in bonds. You might wait to rebalance until your allocation deviates by perhaps 5 percentage points to 65 percent/35 percent or 55 percent/45 percent.
• Recognize the other benefits. Along with bringing your allocation back into line, rebalancing can be viewed as a discipline for buying low and selling high. That's because you are selling a portion of your assets that have performed well while transferring the proceeds to underachievers. Also, as noted, rebalancing reduces the riskiness of a portfolio. If left unchecked over many years, the equity proportion will crowd out the bond component.
• Favor tax-sheltered accounts. Any selling of investments will trigger taxable transactions, presumably capital gains, in an unsheltered account. That's why the strategy works especially well in Individual Retirement Accounts, workplace 401(k) programs and other plans where current taxes aren't an issue.

Reach the reporter at russ.wiles@arizonarepublic.com or 602-444-8616.