As the Fed Tapers (or Doesn't): Portfolio Moves to Make (or Not)
Tapering, no tapering. What's an investor to do?
The Federal Reserve's decision last week not to reduce the pace of its monthly bond buying surprised market analysts, who had readied investors for a change that would send bond yields higher. So now what?
Don't make dramatic changes based on the Fed's move, or lack of one, wealth advisers say. Here are five things to consider if all the taper talk has you thinking about changing your investments:
1. Consider the tax hit. Making short-term portfolio moves off of Fed announcements can cost wealthy people money -- more so this year than last, said Rex Macey, chief investment officer at Wilmington Trust in Atlanta. The top federal tax rate on long-term capital gains increased in 2013 to 23.8 percent from 15 percent. Short-term gains on securities held one year or less are taxed as ordinary income; the rates on those earnings jumped to 39.6 percent from 35 percent.
2. Look at municipal bonds. Yields increased over the summer, hitting a two-year high this month. Investors expected tapering and sought more return for the risk of holding municipal debt after Detroit's July bankruptcy filing.
"We're finding some very attractive pricing on high-quality muni bonds," said Cameron Hinds, regional chief investment officer for Wells Fargo Private Bank in Lincoln, Nebraska. "For clients who are in a higher tax bracket, that's where we're starting to find some opportunity."
As yields on 10-year Treasuries approach 3 percent, Sam Katzman, chief investment officer at Constellation Wealth Advisors in New York, said he'd look to add a small amount of intermediate-term, quality municipal bonds to client portfolios.
Municipal bonds are generally exempt from federal taxes, as well as state and local levies for residents in most states where they’re issued. That means wealthy taxpayers' after-tax returns may be higher with munis than on some taxable bonds.
3. Tread lightly in taxable bonds. The drop in bond yields, which corresponds with a rise in prices, after the Fed's non-announcement may provide an opportunity to sell some fixed-income holdings into the rally, said Bill Kennedy, chief investment officer at wealth management company Fieldpoint Private in Greenwich, Connecticut.
At some point, the Fed will begin tapering, which means investors should prepare portfolios for a rise in interest rates that can cause a decline in bond prices. Real estate investments with cash flow, such as rental properties, can offer attractive yields relative to bonds and offer some inflation protection, Constellation's Katzman said.
4. Be realistic about future stock returns. The Standard & Poor's 500 Index returned 22 percent this year through Sept. 20. With U.S. stocks doing well, investors should take a "serious look" at rebalancing to strategic-allocation targets, said Wells Fargo's Hinds (keeping in mind the tax consequences, of course).
Katzman still advises clients to have "a healthy allocation to equities," but his return expectations are a bit more muted.
5. Brace for a bumpy quarter. The U.S. will hit its debt limit as soon as mid-October and Congress may come down to the wire, again, in dealing with it or risking default. The government also needs funding past Sept. 30, which could result in some federal agency shutdowns if legislators don’t reach a resolution.
"Markets can look forward to the usual hoopla in the weeks leading up to any congressional debt-ceiling debate," Karthik Ramanathan, director of bonds at Fidelity Investments, wrote in a report released Sept. 19.
As for the likely Octaper? Not acting when the market was ready for it will make future tapering a "harder pill to swallow," Kennedy of Fieldpoint Private said.
As investors and advisers try to read the Fed's mind -- again -- people should position their portfolios for what they know, said Macey of Wilmington Trust.
"We're looking at a slow-growing economy, but it's growing," he said. "If you're set up for that environment, you don't need to make a lot of changes."