I mentioned in my last post that I’ve been getting a lot of questions lately about bonds. There seems to be a pervasive fear (fueled by the media) that because rates are at historic lows and the Fed is winding down their quantitative easing, that bonds are a ticking time bomb. Is that true? If so, what should you do about it? Your answer might keep your retirement plans on track…or completely derail them.
Why all the fuss? What happens to bonds when rates rise?
When interest rates rise, the price of bonds falls. To understand why, imagine that you had a 10-year government bond that paid 2.5% interest per year. If rates on the 10-year rose to 3.5%, why would anyone want your bond when they could buy a new one with the better rate? Answer: They wouldn’t. If you wanted to sell, you would need to lower the price on your bond to attract a buyer. The opposite would be true if rates fell. Your bond would have a higher rate than newly issued bonds, so people would be willing to pay a premium for it.
Do rising rates affect all bonds the same?
No. Some bonds are more sensitive to changes in interest rates than others. This sensitivity is measured by something called duration. The higher the duration, the more sensitive the bond is to changes in rates. For example, if a bond (or bond fund) has a duration of 10, it will typically fall 10% in value if rates rise by 1% (or rise 10% if rates fall 1%). If a bond only has a duration of 3, it will fall by 3% if rates rise by 1% (or rise by 3% if rates fall by 1%).
Are interest rates the only thing that affect a bonds price?
No. In addition to interest rate risk, bond prices are affected by credit risk, which is the risk that the borrower won’t be able to repay what they borrowed. Credit risk is why many bonds went down in value in 2008 even though interest rates were falling. As rates fell, you would have expected the price of bonds to rise, but that relationship was sometimes overpowered by the perception that many borrowers (e.g. Greece, Bear Stearns, General Electric, homeowners) were not going to be able to pay back what they had borrowed.
Rates are at historic lows. Should I avoid bonds altogether?
No. Let me give you three very good reasons why you probably shouldn’t shun bonds. First, you could be wrong about the direction of rates. There was a spike in rates at the end of last year and pretty much every media outlet, bond fund manager, and investor assumed that the inevitable climb in rates had come. What actually happened? Rates have been falling ever since. Ten year treasuries started the year at 3.04% and ended last week at 2.34%. Most analysts and commentators were calling for rates on the 10-year to be somewhere around 3.50% by now. None of us has perfect foresight, which is why it makes sense to have a mix of stocks and bonds rather than putting all your eggs in one basket.
Second, you shouldn’t try to minimize risk by taking on more risk. What do I mean? The fear of rising rates has caused many people to sell their bonds and move that money into stocks. That’s a bit like trying to reduce your risk of being injured in a car accident by selling your car and buying a motorcycle. Motorcycle accidents are both more common and more severe. Similarly, the downside risk of stocks and bonds are generally very different. A very bad year in a bond fund is a negative 3 or 4 percent. A very bad year in a stock fund is a negative 30 or 40 percent. Don’t try to avoid risk by jumping out of the frying pan into the fire.
Third, rising rates don’t mean automatic doom for bonds. Between 2004 and 2006 the Fed increased interest rates 17 times by a total of 4.25%. If ever there were a time when you’d expect bonds to get hammered, that was it. But if you peruse the returns of a broad spectrum of bond funds from that period, you’ll notice that many of them actually made money (see chart below).
|Government Bond (VFIJX)||4.21%||3.42%||4.43%|
|Municipal Bond (THMIX)||3.52%||2.71%||4.00%|
|High Yield Bond (BHYIX)||12.21%||3.91%||11.67%|
|Corporate Bond (PBDPX)||5.91%||2.43%||4.07%|
|Global Bond (TGBAX)||14.93%||-2.84%||13.72%|
The Fed is winding down their third round of quantitative easing. Isn’t that bad for bonds?
Maybe. When demand for something drops, so does the price. But keep in mind that one of the biggest beneficiaries of QE has been the stock market. It rallied in a big way each time the Fed engaged in quantitative easing and then sold off when that quantitative easing ended. The S&P 500 fell 9% after QE1 and 11.7% after QE2. So what will happen when QE3 (aka Operation Twist) ends? Who knows? But if past is prologue, it might have a bigger impact on stocks than it does on bonds.
So what should I be doing?
That depends. If you have a well thought out asset allocation that is appropriate for your circumstances, you probably don’t need to do anything. My concern, however, is that many people are not in that boat. Anytime a particular investment theme gets as much press as interest rates are getting now, it causes people to make changes that may not be appropriate (see also 1999, 2007 and 2008). So take a look at your investments and see if your allocation is appropriate given your goals, risk tolerance and time to retirement. If you’re not sure, schedule a meeting with a trusted adviser. No one knows what direction markets will take, but a good asset allocation can help you prosper when times are good and stay on track when things get bad.
Have a great week and touch base if I can help.