When people talk about stocks and bonds, many people intuitively associate ‘safety’ with bonds and ‘risky’ with stocks. While it’s certainly true that, in general, stocks are more volatile than bonds, bonds can be pretty risky under certain circumstances. I’ve found that a lot of people also find bonds to be confusing to understand. Let’s start with a few bond basics:
· When you buy a bond, you are ‘loaning’ your money to an entity with the expectation of receiving an agreed upon interest rate for a specified period of time, at which point you’ll receive all of your principal back.
· Bonds can be issued by the federal government, such as treasury bonds; municipalities or corporations, to name a few of the more common issuers.
· The most common risks associated with owning bonds includes: 1) credit risk- the risk that the issuer will default; 2) interest rate risk- the risk that interest rates rise after you buy your bond; 3) inflation risk- the risk that bond interest will not keep up with inflation.
Credit Risk. Most investors rely, at least partially, on independent rating services to rate bonds according to some variation of investment grade versus non-investment grade (junk). These rating services are not infallible and there have been cases where highly rated bonds ended up in default.
Interest rate risk. Bond values move inversely with interest rates, meaning as interest rates rise, bond values fall and visa-versa. This is confusing for a lot of people so let’s look at a simple example. Let’s assume you purchase a $1,000 30-year 4% bond. A year from now you decide to sell it but interest rates for a similar bond have risen to 5%. Any potential buyer would obviously choose the higher interest rate bond unless you offer to sell your bond for less than $1,000 (called a discount). In order to equalize the yield to maturity of the two bonds, you’d have to discount your bond to $848 (a 15% loss)! Note that the opposite happens if interest rates fall after you buy your bond. This inverse relationship between bond values and interest rates holds true whether you buy individual bonds or bond mutual funds.
Inflation risk. Fortunately inflation has been very low for a number of years and may remain low for several years to come based on a relatively high unemployment rate and Federal Reserve policy.
What does the future look like for bonds?
From the early nineteen-eighties to mid-year last year, in general, interest rates have been falling which has created a thirty-year bull market for bonds. It appears that this long-term trend of falling interest rates and rising bond values has been broken and that suggests challenges for bondholders over the next several years. If I am right, and that is not a certainty, there are several strategies you could use to protect yourself:
1. Reposition your bonds towards higher quality and shorter maturities. The shorter the bond maturity, the less effect rising rates have on bond values. For our clients, we have shortened the average maturity to less than three years while focusing on high quality bonds. An example is Vanguard Short-Term Investment Grade Bond Fund (symbol: VFSUX).
2. Sell bonds for cash. Current interest rates on money market accounts are near zero and therefore subject to inflation risks. However, interest rates should improve over time.
The more likely it is that you’ll need to ‘access’ your bond portfolio for cash needs, the more important these two strategies are.
Ride it out. If you anticipate that you’ll only need the interest (not principal) from your bond funds, you can simply hold your positions and wait for interest rates to complete this next cycle (of rising interest rates), which could take several years. For individual bonds, you could hold them until they mature at which time you’ll get your principal back and can reinvest at the prevailing interest rates.
What’s important is that you take a moment to reassess and evaluate your overall portfolio allocations in general and your bond strategy in particular.