Bond investors are bracing for the Federal Reserve’s highly anticipated decision on whether to raise interest rates expected Thursday afternoon.
Fixed-income strategists have warned that a potential rate hike could prompt a Treasury selloff, particularly in the short-term maturities, such as the two-year Treasury TMUBMUSD02Y, -0.47% which are most vulnerable to changes in the Fed-funds rate.
Here are some ways to prepare your bond portfolio for a rate hike:
1. ‘Ladder’ your portfolio
A bond ladder is a portfolio of individual bonds that mature on different dates. Laddering practically means distributing the bonds in a way that maturities are equally divided. This strategy is best for investors with a long horizon who don’t want to play the game of waiting to see when rates will rise.
“By staggering maturity dates, investors avoid getting locked into a single interest rate,” Kathy Jones, chief fixed-income strategist at Schwab Center for Financial Research, said in a research note.
Under this strategy, every year around 20% of the portfolio should mature and get reinvested, taking advantage of potential rising rates, Jones said.
Here’s a good explanation of bond laddering and its pitfalls.
2. Buy long-term bonds
If the Fed hikes rates, intermediate- to long-term bonds may actually rally, driving prices higher and yields lower.
The reason is that longer-term Treasurys, such as the 10-year note TMUBMUSD10Y, -0.31% , are more sensitive to inflation and growth expectations, rather than Fed-rate hikes, Anthony Valeri, investment strategist for LPL Financial, said in a note.
“A rate hike coupled with hawkish rhetoric could actually lead to lower 10- and 30-year Treasury yields,” Valeri added, amid low inflation, a strong dollar, and China growth uncertainty.
That is what happened in the 1999 and 2004 hiking cycles long-term yields rose in the short term but eventually fell again, as the following chart shows.
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