Your Best Bond Strategy. Interview with Bond Strategist Kathy A. Jones.

Kathy A. Jones is the Vice President, Fixed Income Strategist, Schwab Center for Financial Research.

For years, pundits have debated about the timing of a rise in interest rates, pouring over the Federal Reserve Minutes and analyzing every new comma in the press releases. None of this sound and fury amounted to anything of value. Predictions that interest rates would rise have sounded on the airwaves for seven years with the only effect of making the listener numb.

Meanwhile, Kathy A. Jones scoured historical data, searching to find another time in U.S. history when debt was high, economic growth stalled and interest rates were rock bottom. Her research revealed that during the 18-year period post World War II, when the economic climate was similar to today's, interest rates remained low for a period of 18 years. We are now 7 years deep into Kathy Jones being right on the money.

In my interview below, we sound her wisdom on the best bond strategy in 2015 and going forward. If you are reaching for yield or worried about a bond exodus, her sound and candid counsel could save your assets.

Natalie Pace: The Feds clearly want to raise interest rates, but are having a difficult time figuring out how and when. Do you think we might have another decade of ultra-low interest rates?

Kathy A. Jones: It's clear their bigger concern is if they go too far, too fast than going too slowly. They are actually okay with short-term rates going up and long term rates staying low. That makes sense because long-term rates affect the mortgage market, while short-term rates affect a lot of other borrowing - auto loans, student loans, credit cards, commercial business loans... If you think of what might be over-heating, or what might be riskier right now, it is not the mortgage market. That has gotten conservative - overly conservative.

NP: Auto loans?

KJ: Subprime auto loans. Some of the bank loans, the high-yield lending that was going on in the oil market when there was easy lending and oil prices were over $100/barrel.

NP: How much risk is there in the oil bond market?

KJ: In the high-yield market, there is a fair amount of risk. There's actually an example of a company that is defaulting on its bond by not making the first coupon payment.

NP: So, let's talk about the Fed leverage. This is astronomically different than we have ever seen. Are we naïve to think that we can transition out of this period safely?

KJ: We don't know really, do we? There certainly could be a lot more volatility. But, they have a lot of tools.

NP: They are still rolling over...

KJ: They are still reinvesting, so that's one tool. They can pay interest on reserves, if they want to, to control the amount of lending. Right now the problem hasn't been the private sector getting over-leveraged. It's been under-leveraged. They've created all of this liquidity, and it's still not really ramping up the economy. I think they're likely to keep the balance sheet pretty high for quite some time.

NP: Are you concerned about the $18.152 trillion debt?

KJ: It's a long-term issue that we absolutely need to deal with. We're not generating enough revenue for our long-term entitlement spending.

Had Illinois done the responsible thing, either set aside the money that they needed to meet their pension obligations or address that those obligations were unrealistically high ten years ago, Illinois would not be in the position that it is in today. That's a good example of where we are as a nation. If we start addressing it now, it's perfectly reasonable to believe that it can be solved. But we don't have anyone who has to run for election in two years who seems to be willing to make decisions that will affect us ten years out.

NP: How long do we have to get back on track? We own a lot of our debt, which helps tremendously.

KJ: It does matter who owns the debt. One reason that Japan has been able to go on and on and on is that they own their own debt. Not that you want to be like Japan. We have about 47% of our government debt held outside the United States. Is that a big risk in the near term? I don't think so because the two biggest holders are Japan and China. We have the world's reserve currency. I'm not sure that they have any good reason not to want to hold our debt with three trillion or so each in reserves. They don't have a lot of great alternatives. Could it be a problem down the road? Yes.

NP: We have hit the Debt Ceiling again. No one is talking about this. They won't until we get close to running out of money, perhaps in early fall. What concerns do you have for the bond market?

KJ: I'm not terribly optimistic that we'll get a settlement. We can only hope that it is in everyone's political best interest to get this out of the way. Now that we've been through a couple of these, I don't think people take it seriously. That's good and bad. The good news is that no one is panicking. The bad news is that if we actually get some sort of a standoff that affects us, people aren't prepared for it.

NP: What is the impact of a strong dollar on emerging markets?

KJ: It's tough for emerging markets. They are smaller and less liquid. Historically, when there is a strong dollar, they tend to do disproportionately poorly. It is a risk for countries that have been affected by the drop in commodity prices, like Brazil and Russia. Less so for India. It is a case by case basis.

NP: Most Americans have some exposure to European bonds in their 401Ks. What advice to you have for them?

KJ: In an environment where our yields are so far above other developed market countries, you are adding currency risk on top of a low yield.

NP: Would you be worried that the migration out of Eurozone bonds has already begun, and that you have to take a haircut to get out?

KJ: Yes.

NP: But, better now than waiting?

KJ: Exactly.

NP: Does the strong dollar impact the bonds of multi-national U.S.-based companies?

KJ: You would hope if it's a big multi-national company with an investment grade rating that the bonds are not as affected because you are so much higher in the capital structure.

NP: Would it be an issue for a multi-national U.S. corporation with a substantial amount of debt?

KJ: If they are really at risk of reduced cash flow when translated back into dollars, they could get a downgrade. That would affect the price of the bonds. It's possible, but I don't think it would be the norm in the investment grade.

NP: Let's talk about weak growth and deflation concerns in the U.S. How does this affect bond market strategies?

KJ: It keeps our yields low. It is really hard for investors who are looking for some sort of income without having to take on a lot of risk.

NP: What do you think is the best bond strategy for 2015?

KJ: I'm a big believer in maintaining your strategic asset allocation that you are comfortable with. We're seeing that people who have done quite well with their portfolios are very nervous. So, maybe it's time to reduce the risk in their portfolio. Market timing is really hard and people get it wrong all of the time. So, stick with your strategic allocation, but revisit what kind of investor you really are.

NP: Do you need to do any pruning of your bond assets?

KJ: We expect a lot of volatility, so minimize exposure to the riskier sectors of the fixed income market, like high yield, or emerging market bonds or bank loans. If you are buying high-yield bonds, with yields below 5%, why are you doing that? The risk of capital loss is far too great.

NP: What happens to the bond market when the Feds finally start raising rates?

KJ: If you're sitting in cash, take advantage of the opportunity if rates go up and the Feds hike rates. Start adding a little bit. I'm not saying plunge all of the way into 30-year bonds. But start adding some intermediate term bonds to your portfolio to generate some income.

NP: How can people take advantage of, or protect themselves, from a move up in interest rates?

KJ: If you hold a whole bunch of very long-term bonds, which is probably a small slice of people, if you're not comfortable with the volatility that might be coming from that, then you might want to add some cash or some very short-term bond funds to reduce the volatility that is coming. Chances are that if you have a bunch of long-term bonds, you've had them for a while and they have high coupons. You still want that income. So, I would just hold onto them.

NP: Do you think that people should be looking at the credit worthiness? A 30-year bond that was purchased ten years ago might be in a different credit category today.

KJ: Any time a bond changes credit rating, you want to take a look to see what is going on there and make sure that you are comfortable with the credit rating.

NP: How would you characterize the right bond portfolio to have today?

KJ: Our general advice is to keep an investment grade quality, intermediate 5-10 year portfolio. Then you might want to add some short-term bond funds to balance it out and reduce the duration a little.

NP: It sounds like one of your themes is "capital preservation."

KJ: Right. That's one of the characteristics of fixed income. Capital preservation, income and diversification are the big reasons you hold it.

This is the 1st half of a 2-part interview with Kathy A. Jones. The next installment will cover the impact that Millennials will have on the economy and real estate in 2015 and going forward.