Should You be Getting Out of Bonds?
By Jeff A. Christie, February 25, 2010
I have been hearing a lot of talk and reading quite a few articles about bonds lately, and whether or not now is a good time buy, sell or hold on to them. This is a hot topic for a few reasons, concerns about inflation, expectation of rising interest rates, and recent floods of capital into the bond market causing a possible bubble. I will address all three of these concerns and give you the reasons I am still a fan of these fixed income vehicles. And as an aside, when I say I am a fan, it has nothing to do with my personal feelings. At Ken Stern & Associates we believe that when managing money, you cannot rely on beliefs or hunches, but on comprehensive modeling and planning based on probabilities.
Lets start out with some quick background; the two worst things for bonds are inflation and rising interest rates. Inflation erodes the return on bonds, as their interest rate is generally fixed, meaning you receive the same amount of dollars, but now each of those dollars will buy you less.
Rising interest rates hurt bonds by pushing down their price. If I bought a bond a few years ago and it has an interest rate of 4%, but the current market rates are closer to 5%, then I will have to sell my bond at a discount in order to give it a comparable yield to current issues. With that in mind, lets discuss the current market conditions.
Inflation:
Many people expect that inflation will become an issue in the U.S. within the next 6-18 months. We have seen unprecedented government spending, and a market that has been flooded with liquidity to try to thaw out the credit freeze and boost the economy. Knowing what you know about inflation, you can see why this would pose a threat to bond investors. But, there are ways to combat this. One specific way that many investors use to guard their bond portfolio against inflation is to use inflation-protected bonds. The U.S. Treasury issues Treasury Inflation-Protected Securities (TIPS), which actually provide protection against inflation. The principal of TIPS increase with inflation and decrease with deflation, as measured by the Consumer Price Index. When TIPS mature, you are paid the adjusted principal or original principal, whichever is greater. Also, the interest rates on these notes are fixed, but if the principal is adjusted upward, then the actual dollar amount of the interest paid is higher, as it’s based off of a higher principal value.
Please note, bonds and TIPS investments may not be suitable for all investors. Investing in bonds involves risks including, but not limited to, interest rate risk, credit risk, market risk, inflation and high-yield risk, and possible loss of principal.
TIPS are fixed income securities whose principal value is periodically adjusted according to the rate of inflation. However, like other bonds, TIPS are subject to capital gains or losses in the marketplace prior to maturity; TIPS are based on the inflation adjusted principal value of the bond, which can adjust below the bond’s face value before maturity for the purpose of calculating interest payments, potentially causing decreasing interest payments in deflationary environments. The U.S. Government guarantees repayment of either the inflation adjusted or original principal amount (whichever is greater) at maturity. Neither the current market value of inflation-indexed bonds nor the value of a portfolio that invests in inflation-indexed bonds is guaranteed, either or both may fluctuate.
If you would like to hedge your bet on a falling dollar as well, you can purchase international inflation-protected notes. The governments of developed and emerging economies issue these notes, and again the principal on these notes are adjusted upward or downward based on local inflation measures in their individual countries. This type of security can offer the benefit of added diversification and may be a compliment to U.S. TIPS for those who think the dollar will continue the tumble it has in years past.
In addition to the risks mentioned above, foreign investments also present unpredictable risks. International investments may involve risk of capital loss from unfavorable fluctuations in currency values, and from differences in generally acceptable accounting principals. Also, losses may result from political or economic instability in other nations, and changes in interest rates. Investments in emerging markets or concentrations within a single country are subject to greater risk of loss and volatility. Diversification does not guarantee against losses, it is a strategy used to manage risk. Just ask everyone who invested in Greek bonds over the past few years.
Rising Interest Rates:
Another headwind to the bond investor is the likely possibility of interest rates rising in the near future. The Fed has done its best to keep the economy afloat by making money very cheap to invest, something that cannot be done in perpetuity. Realistically, interest rates have almost nowhere to go but up. Just this week, the Fed raised its discount rate, but has not moved the Fed funds rate. So does this mean bond investors should sell and run for the hills? I don’t think so, although there is real pricing risk in the near future for many bonds, I do not believe there are many alternatives that can generate bond-like yields in the meantime. Many money markets and certificate’s of deposit (CD’s) are paying paltry amounts, moving all of your funds into high dividend equities carries along with it a whole different set of issues altogether, and real estate is still very unstable.
One way to combat the issue of rising interest rates is to vary or ladder the maturities of your bonds. Longer-term bonds have more interest rate risk then shorter-term bonds. Another thing to note is that if you hold individual bonds and plan to hold on to them until their maturity, rising interest rates are essentially a non-issue. Although the price of the bond may fluctuate in the short-term, you will still receive 100% of par value when the bond comes due as long as the creditor is still viable.
The principal value of bonds will fluctuate with changes in market conditions. If sold prior to maturity, bonds may be worth less than their original cost. Depending on the types and amount of securities within it, a bond ladder may not ensure adequate diversification of an investment portfolio. You should carefully evaluate whether a bond ladder and the securities within it are consistent with your investment objectives, risk tolerance, and financial circumstances. You should discuss this with your financial consultant before implementing this strategy.
Another potential strategy to mitigate interest rate risk is to purchase various types of bonds, that way, although the overall price may be coming down, if you add in some corporate bonds, international bonds, even high-yield bonds, they will coming down from a higher place, and you may receive better interest rates then that of government paper. You can still find a lot of bonds out there that are already trading at discounts to their par value, not because of interest rate issues, but due to the recent financial crisis. If you can find bonds that you are comfortable with, and companies that you think will be around in the future, now may be a time to consider these types of bonds.
Bond Bubble:
Lately some analysts have been concerned that a “bond bubble” is forming due to very high capital flows into the fixed income market. In 2009’s stock market rally, it has been calculated that for every $1 that went into equities, there were $7-8 going into bonds. But, more capital inflows does not a bubble make, especially in a market that is very large, and based off of an instrument that has fixed cash flows (depending upon the credit quality of the issuer). Of course there is risk in the bond market, if there wasn’t you would not receive a higher yield then insured investments. But, I do not believe that too much money chasing too few bonds is really an issue. I think the disparity between capital flows into stocks vs. bonds is the result of a huge number investors deciding they no longer wanted the higher risk of growth oriented investing, and have changed their tune for the long-term, not just parking cash until the stock market stabilizes.
Summary:
If you plan to buy or simply hold on to bonds, do so with your eyes open. Bonds face a difficult and bouncy road ahead, but I feel, depending on your personal situation and investment objectives, it may be one worth traveling to receive the yields bonds offer, not to mention potential diversification benefit in a portfolio. Take a look at different types of bonds, different issuers, maturities, credit-qualities, terms, and of course speak with your financial advisor before investing. There may be some attractive buys out there in the fixed income market if you know where to look, it’s just not as easy to see as it may have been last year.
Good luck, and investing.
Jeff A. Christie
Wealth Manager
Ken Stern & Associates
CRD# 4889641
CA Insurance Lic.# 0F01343