(PUB) Investing 2016

17

October 2016

Morningstar FundInvestor

leveraged borrowers if the market believes the rate hikes will succeed in slowing growth and thus imperiling those borrowers’ future health,” he said. On the other hand, if the economy softens—and economic data aren’t universally strong, which is one reason the Fed hasn’t yet moved aggressively to raise rates—the default rate for high-yield bonds could go up. That’s not to say that you shouldn’t own high-yield to serve as an aggressive complement to your high-quality fixed-income portfolio, but check your existing exposures first; portfolios with plenty of equity exposure probably don’t need high-yield exposure. Also plan to have a nice long time horizon of 10 years or more. Treasury Inflation-Protected Securities No one has ever suggested that Treasury Inflation- Protected Securities would hold up well in times of rate increases. Holders of TIPS get an adjustment in their principal values to reflect increases in the Consumer Price Index, but when CPI is on the move, interest rates often are, too. In times of economic strength, TIPS have the potential to give with one hand (by delivering an inflationary adjustment) and take away with the other (by falling in price amid rate changes). Yet investors might be surprised at just how rate- sensitive TIPS actually are. The Barclays Aggregate U.S. Treasury Inflation-Protected Securities Index, along with most core-type TIPS funds, has a duration (a measure of interest-rate sensitivity) of eight years or more, longer than the Barclays Aggregate Index, which has a duration of about five years today. Add in the fact that TIPS yields, as is the case with nearly every other bond type, have slunk lower, meaning they’ll provide less of a buffer against price declines than was the case in the past. As with high-yield bonds, this is not to suggest that investors should shun TIPS from their portfolios; in fact, I consider them even more central than junk bonds, especially for retirees. But it does point to the virtue of carefully considering your time horizon when deciding what type of TIPS product to buy.

If you have a shorter time horizon of, say, seven or fewer years, you may well be better off in a shorter- term TIPS fund like Vanguard Short-Term Inflation Protected Securities VTIPX . If your time horizon is longer, a longer-duration, core-type TIPS fund is fine, because it’s apt to compensate for its higher vola- tility with higher returns over a longer holding period. High-Yielding Stocks As bond yields have declined, investors have increas- ingly been using dividend-paying stocks in lieu of bonds. Many high-quality dividend-payers currently feature yields that are higher than high-quality bonds’; indeed, the current yield on the S & P 500 (~ 2 . 2% ) is higher than that of the Barclays U.S. Aggregate Bond Index ( 1 . 8% ). Moreover, stocks have more leeway for capital appreciation than bonds, albeit with more downside potential. In terms of interest-rate sensitivity, a feather in the cap of dividends is that the amount of dividends a company pays out is determined by its board; current market yields may play a role, but corporate strategy and capital-allocation considerations are more important. By contrast, the yield a company must pay on its bonds is largely determined by the marketplace and prevailing yields at time of issu- ance. Thus, bonds tend to be more directly affected by rising rates than dividend-paying stocks. Addition- ally, because higher interest rates are typically the product of strong economic environments, stocks may in fact behave reasonably well amid periods of rising interest rates; specific industries, such as banks, may actually benefit. You can expect to see stocks that investors have been using mainly for current income in lieu of bonds, however, struggle in a rising-rate environment. On the short list: utilities, REIT s, and higher-yielding consumer staples and pharmaceutical names. K Contact Russel Kinnel at russel.kinnel@morningstar.com