Morningstar Advisor - December 2013/January 2014 - (Page 28)

In Practice Exhibit 2 Magnitude of Rate Change Relative to Prevailing Yields at the Beginning of the Rising Rate Period January 1946 through September 2013 Magnitute of Rate Change Less than 10% 10% to 19% 20% to 29% 30% to 39% 40% to 49% 50% and greater Nominal Return (%) Nominal Return (%) Real Return (%) Nominal Return (%) Real Return (%) Nominal Return (%) Real Return (%) Nominal Return (%) Real Return (%) Nominal Return (%) Real Return (%) Less than 2% 0.81 0.62 1.02 0.21 1.42 0.18 -1.92 -3.77 - - -0.39 -2.88 2% and 3.9% -0.39 -1.01 0.66 -0.57 -0.47 -0.23 0.23 -9.71 - - -0.88 -1.63 4% to 7.9% 2.52 1.50 0.75 -1.63 -1.03 -5.70 -2.22 -4.21 -5.87 -5.08 - - 8% and greater 12-Month Inflation at Beginning of Period Real Return (%) 4.73 4.14 0.38 -2.63 0.96 -3.14 - - - - -0.60 -7.47 Table shows returns of the Ibbotson Associates SBBI U.S. Intermediate-Term Government Index. bond money while waiting for rates to rise, they could find getting back in the market could prove more difficult than many expect. Indeed, they could return to the market in time for yet another move higher in interest rates. Rather than attempting to time the market, we think it's worth remembering the role bonds play in portfolio construction. With a fair amount of predictability to their income stream, they are prone to significantly less volatility than other asset classes, the equity market in particular. Since a move higher in rates doesn't compromise this advantage, investors can still count on them to act as portfolio stabilizers, even in an environment characterized by rising rates. That doesn't mean investors should bury their portfolios in Treasuries and resign themselves to losses. While bonds issued by corporates aren't immune to rising rates, their larger coupons mean they often suffer less when rates are on the rise. In fact, with the Barclays U.S. Corporate InvestmentGrade Bond Index yielding 3.3% relative to the 1.06% for the Ibbotson index at the end of September, our historical analysis suggests that, all things held equal, investment-grade corporate bonds could withstand an interest-rate increase of a much higher magnitude before experiencing significant losses. 28 Morningstar Advisor December/January 2014 Given the damage high inflation can cause when rates are on the rise, investors may also want to consider an allocation to bonds that offer an inflation hedge. Enter TIPS. Although vulnerable to a rise in real rates, particularly in light of their low current yields, these bonds will not experience the same real losses as nominal bonds because of the inflation adjustment baked into their principal. And while they are hardly screaming buys, the sell-off they experienced earlier this year means they are cheaper now than they've been for two years. Hang In There The future for bonds likely won't mimic the past. The risk of rising rates is real and could be costly if the magnitude of the move proves large. And even if rates stay steady, bonds no longer benefit from the tailwind of falling yields, which spurred impressive gains since the 1980s. Nevertheless, we don't believe investors should jettison them from portfolios altogether. Bonds still retain their utility as portfolio stabilizers, and prudent allocations to credit-sensitive and inflation-hedging sectors could help minimize damage caused by a risingrate environment. K Marta Norton, CFA, is an investment manager with Morningstar Investment Management. The opinions expressed herein are those of Morningstar Investment Services, are as of the date written and are subject to change without notice, do not constitute investment advice and are provided solely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar Investment Services shall not be responsible for any trading decisions, damages, or other loses resulting from, or related to, the information data, analyses or opinions or their use. ©2013 Morningstar Investment Services, Inc. All rights reserved. Morningstar Investment Services, Inc. and Ibbotson Associates, Inc. are registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The Morningstar name and logo are registered marks of Morningstar, Inc.

Table of Contents for the Digital Edition of Morningstar Advisor - December 2013/January 2014

Morningstar Advisor - December 2013/January 2014
Contents
Contributors
Letter From the Editor
What’s Your Purpose?
Working for Gen Y
How to Allocate College Savings
Mobius Looks to a New Frontier
Investments á la Carte
Investment Briefs
How to Manage Bonds for Today and Tomorrow
Cloud Is the New Engine of Growth
Knowing Where to Look
Economic Vulnerability Varies by Country
Factor Investing in Emerging Markets
Following the Rules
Exploring Indexing’s Next Frontiers
Frequent Fliers
Family Blind Spots
Optimal Portfolios for the Long Run
Finding Value in a Pricey Sector
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
The Emerging-Markets Roller Coaster

Morningstar Advisor - December 2013/January 2014