Thoughts on Bond Investing in Today’s Tumultuous Interest Rate Environment

Most people are familiar with the basic tenet that their long term investments housed in retirement and/or brokerage accounts should consist of some mix of stocks and bonds.  For many investors, allocating these assets classes with a series of mutual funds and ETFs was the simplest and cheapest means to attain broad diversity within the chosen mix of securities. In simpler times (i.e. prior to 2008), people could choose a percentage mix of bond funds and stock funds and call it a day.

However, since the US and many other governments around the world began “stimulus” practices with the onset of the financial crises in 2008, investors have been vexed by confusing cross-currents making investing, and more specifically bond investing, more challenging than ever. In this world of low yields (and therefore high prices) for bonds, I believe investors should be aware of the stark distinction between bonds and bond funds.    Why?  Because in short:  when investing in individual bonds you get all the money you lent to the issuer when the bond matures (assuming the bond issuer does not default) even if interest rates were to skyrocket higher after your purchase.  This is not the case with a bond fund as the fund value will decline and there is no “maturity date”.   This alone should keep investors cautious and lest anyone thinks bonds are the “safe” investment, they are sorely mistaken.  If you are one of the many invested in bond funds, you may open your next quarterly statement and find that bond fund prices  do indeed decline in value- and sometimes sharply.

To provide some perspective of where we are today and why this matters let’s first consider this:  the benchmark 10-year U.S. Treasury closed last week with a yield of 2.73%.  While that is quite a jump higher from April 2013 (1.73%) and July 2012 (1.52%) this rate is still well below the long term average (since 1962) of 6.6% (source: Federal Reserve Bank of St. Louis; http://research.stlouisfed.org/fred2).  This means that for most of the past 50 years, people received much more income for taking the risk of lending money to Uncle Sam.   Today? Not so much.

Why is this relevant?  Because I believe investors should be aware of historical context and the recent trends in yields as they implement strategies for the fixed income portion of their portfolio.

As always, an example is the best way to illustrate. Let’s suppose the Jones family has $10,000 they want to allocate to bonds.  They have many choices in the market but first they must decide if they want to buy individual bonds or buy a bond fund.  A bond fund has the advantage of essentially diversify the bond holdings with one transaction as a bond fund holds a basket of many bonds.  For this example let’s say the yield on the XYZ Corporation individual bond is about 3.5%, which implies XYZ Corporation is a highly rated and solid corporation. This means the Jones family can lend the XYZ Corp. $10,000 and get $350 per year and at the end of 10-years, they get the $10,000 returned to them when the bond matures, assuming the XYZ Corp. does not default.

Another alternative is to put $10,000 for 1000 shares of the High-Quality Corporate Bond fund which is comprised of let’s say 30 high-quality corporations, similar to XYZ Corp.  This fund is currently priced with a NAV (net asset value) of $10 per share and is yielding the same 3.5% (again, for example) which means the investor gets paid the same $350 per year.   Based on the principal of diversification, it would appear buying the fund would be “safer” as the investor is spreading his bets across 30 companies and in that respect, the investor would be correct.  However, one often over-looked aspect especially important in a low-interest rate environment like today is the impact of increasing interest rates on the NAV (or fund price) of bond funds.  In our example, if interest rates were to rise rapidly over the next 10 years, the NAV of the High-Quality Bond fund would decline.  This means that after 10 years, the investor would NOT be get back his $10,000 returned to him, he would still own the fund but now with a lower price.  This change in value is measured by a metric known as “duration” which essentially measures the sensitivity of the NAV to a change in interest rates.  The higher the duration, the bigger the inverse change in price relative to the direction of interest rates.

Again, in a scenario of rapidly rising interest rates, the investor in the individual bond would continue to get his $350 per year but after 10 years, he would get his entire $10,000 principle back (again, assuming no default from the issuer).  Sure, if he had to sell prior to the maturity of the bond, the bond would be priced lower than the $10,000 but he could wait until maturity, he could get his money back.

Essentially, this means bond funds, while providing the advantage of diversification, still have risk associated with the NAV change and in an environment of historically low rates, I believe investors are best served to be aware of this distinction between bond and bond funds.

In working with clients, we implement strategies which I believe help reduce the potential damage if or when interest rates rise and these strategies include bond ladders, short duration fund investing and dollar cost averaging.   (I say “if or when” on interest rates because I don’t know when rates will rise and if anyone tells you they know, you should also ask them about that bridge they have for sale in Brooklyn.)  The bottom line is that today’s investors need to be especially vigilant about not only their percentage weighting of fixed income in their portfolio but also the structure and components of their of bond allocations.

 

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