It's no coincidence that stocks sold off in the beginning of February, right as the market's level of confidence about the Federal Reserve's upcoming rate increases has grown. The inflation outlook and the outlook for stronger economic growth taken together do point to several rate increases this year.
The latest FOMC minutes revealed that Fed officials are now positive on the economic outlook, with some having "marked up their forecasts for economic growth in the near term relative to those made for the December meeting." Translation: More rate hikes this year. If interest rates rise, they will take a further toll on bonds' market prices down the road.
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The good news is that these rate hikes are conditional on further economic growth. Stronger growth is generally good for stocks, whose valuations depend on the outlook for future earnings. This is why I think higher rates won't necessarily spell doom for equities. With growing profits and higher dividends a distinct possibility, dividend-paying stocks offer the potential for both income and capital gains.
But what about bonds?
There might be several interest rate hikes this year (even conservative estimates call for as many as three or four increases). And while the Fed does not directly impact long-term rates, so many short-term rate hikes are likely to lead to higher rates on longer-dated debt.
There is a certain balance between short rates (the ones that are expected to be hiked) and longer-term rates. For instance, who in their right mind would lend the money to the government for, say, 10 years at the same rate as for only a year? Longer-term debt is riskier and typically demands higher compensation, or a higher coupon, for taking that risk.
As rates rise to the levels that are more normal by historical measures, a new supply of bonds will be entering the market. These bonds are likely to generate higher yields, all else being equal. Well-managed active funds, such as my most recent Daily Paycheck pick, should be in a better position to own what is priced better, yields the most and/or is better positioned to weather interest-rate increases than the average passively-managed (index) fund of a similar credit quality.
An Agile Bond Fund For This Terrain
Knowledge is power. It's especially true for bond investors -- with so many different issues of various coupons and maturities from many companies, municipalities and various governments to choose from, the process of finding the very best value can be taxing. This is why it makes sense to go with a fund -- a closed-end fund, an exchange-traded fund (ETF) or even a mutual fund -- for fixed-income investing.
And while mutual funds can be more expensive than ETFs, the extra service they provide to investors -- the deeply-specialized research and well-diversified portfolios -- is often worth the management fee.
This can be especially true for mutual funds that are not restricted in their investments. This "go anywhere" approach, more officially known as "multisector investing," can generate extra returns just because the managers can seek currently undervalued securities in practically any industry, country, quality or duration, and invest as they see fit without having to contend with a strictly defined benchmark.
This approach has the most promise in difficult markets, like what we're seeing now. As interest rates are set to rise, the values of bonds are set to decline -- and it's up to active managers to build portfolios most suited to this changing environment.
Of course, even though the multisector bond fund can theoretically position itself (and its investors) for a changing market, that does not necessarily mean that the fund will do well. Only seasoned managers with enough experience and strong research capabilities can be reasonably expected to do well in difficult markets.
Fortunately, such funds -- and such managers -- exist.
Even though their past performance is not a guarantee that they will do well in the future, if the investment process is in place, a strong experienced team is assembled, and long-term leaders remain in charge, investors can reasonably expect the continuation of the policies that have made the fund in question strong.
One such fund is my new Security of the Month.
This fund is a long-term performance leader in the multisector category, with annualized returns of 3.3%, 2.5% and 3.9% over the past five-year, three-year and one-year periods, respectively. Over the past 10 years, the period that includes the declines of the 2008-2009 bear market, this fund returned more than 72% (with dividends reinvested), or 5.5% annualized.
While this fund is more aggressive than many of its peers, it looks well positioned for the challenges of the rising-rate environment based on its history and a "go-anywhere" mandate.
That makes it a perfect addition to my Daily Paycheck portfolio, specifically in the “steady income generators” section. The other stocks in this segment of my portfolio yield an average of 4.8% -- through any market conditions imaginable. In total, the segment has given off an average total return of 24.7% per year.
And while I can’t reveal the name of today’s pick here -- it just wouldn’t be fair my paying subscribers -- you can get a risk-free trial of my Daily Paycheck service, and access to my entire portfolio, today.
You’ll also get to see the other segments of my portfolio: “fast dividend growers” and “high-yield opportunities,” the latter of which yields an impressive 8.2% on average.
Click here to get started on your Daily Paycheck trial. Your reliable, daily dividend checks are waiting…
This article originally appeared on StreetAuthority.com.