Federal Reserve Chairman Ben Bernanke signaled last week that the Fed could start winding down its stimulus as early as this year, concluding the program in mid-2014. This revelation has fueled the Treasury market’s biggest weekly selloff in more than a decade and has a lot of people spooked. But there are several actions investors can take in this volatile market environment.
Don’t Panic. Reevaluate.
If you jump out of your investments and sit in cash, waiting for the markets to calm down, you are likely to cost yourself. Over long periods of time, bonds beat cash so if you sell bonds only to hold cash, it is very difficult to know when to reverse course and buy back in.
Instead, we encourage you to look at your entire portfolio. What type of bonds do you own? Rising interest rates don’t affect all bonds the same way. If you own the aggregate bond market, and in the unlikely event that rates spike 2%, your losses should stay under 10% even before interest rates are considered.
But it’s an entirely different story if you own 10- or 20 to 30-year Treasuries. If rates were to spike 2%, you could face losses of about 15% and 30%, respectively.
We recommend that people should have at least some emerging markets bond exposure. You’ll notice that emerging markets as a whole are getting dumped because of the general desire for liquidity as the Fed slows its quantitative easing program and due to potential problems in China. In fact, during the week ending June 19, more than $3 billion flowed out of emerging market equity funds alone. But we think emerging markets remain a good option for higher yield as a smaller portion of a well-diversified fixed income portfolio. The best way to get exposure is through one or more diversified ETFs.
Beware Small Value Stocks
Overweighting small value has become a very popular strategy, and it seems to be widely accepted that these stocks should perform better over time. But in an uncertain interest rate environment, small value may not be the best strategy, especially because many of these companies rely on debt financing which will be more expensive. Also, their dividend yields will be less attractive in a higher interest rate world.
Look for Silver Linings
There are companies out there that can benefit a great deal when interest rates rise, such as large companies that can make money on cash balances or on interest rate spreads. Some examples include large discount brokers such as Schwab and eTrade, or insurance companies such as Prudential, Allstate, and Met Life.
Focus on the Long Term
It’s easy to get caught up in the noise and market speculation. But as previously mentioned, panicking and rash decisions could lead to missing out on some big opportunities. We recommend focusing on the long term, owning a blend of different bonds with an appropriate risk level according to your target allocation.
If you are scared about the fed taking away the punch bowl, keep in mind that stimulus is only likely to be reduced if the economy is doing well. And when the economy is doing well, broadly diversified portfolios tend to be rewarding to own.