Two forces are coming together to make folks who own bonds or bond funds wonder just how safe is their money. The first most notable is the $18 billion municipal bond default and bankruptcy by the city of Detroit. The second is the rising interest rates over the last few months that have negatively affected bond prices and bond funds. So just how safe are your bonds and bond mutual funds and what, if anything, should you do about it?
Before I address this question, let me give you a little bit of historical background to set the context for this discussion. If you look at the historical data, you’ll discover that bonds have pretty much been in a thirty year bull market. Back in 1981, the yield on the 10-year Treasury bond was a whopping 13.9%! Remember Jimmy Carter’s WIN (Whip Inflation Now) campaign? Since that time , with the exception of a few ‘ebbs and flows’, interest rates on bonds have been on a steady decline until they bottomed out last year at 1.4%. Getting a grasp on how bond values work can be a challenge for a lot of people but as interest rates fall, the bonds (or bond fund) you own goes up in value. For example, if you were lucky enough to invest $10,000 in a 10-year Treasury bond yielding 13.9% interest in 1981 and a year later interest rates on similar bonds had dropped to 13%, the bond you own would be worth more than $10,000 if you chose to sell it because the interest rate being paid on your bond is higher than what’s being paid on new bonds of the same maturity and quality. Just the opposite happens if you bought a 10-year treasury bond last year paying interest of 1.4% when today similar bonds are paying 2.6%. If you want to sell your $10,000 bond paying 1.4% interest to me when I can easily find one paying 2.6% interest, you’ll have to reduce your price below $10,000 in order to entice me to buy from you. Make sense?
So let’s get back to the question of whether your bonds are safe today. Here are three key points you should consider:
1. Credit Risk. I think it is unlikely that the city of Detroit is the only municipality in serious financial trouble so we are likely to see other bond defaults in the years ahead. This means it’s extremely important that if you own individual bonds that you stay on top of the credit quality of your bonds. This is not a particularly easy task and you may need to get help from an advisor who specializes in bonds. If you own bond funds, you already have professional management so hopefully they will do a good job of managing the credit risk on your behalf.
2. Bond Maturity. If I’m right in thinking that we may have seen a multi-year transition from falling interest rates to rising interest rates, longer term bonds and bond funds will face significant headwinds in the months and years ahead. For example, a $10,000 investment in Vanguard Long-Term Investment Grade Bond Fund a year ago would be worth $9,300 today. The same investment in Vanguard Intermediate-Term Investment Grade Bond Fund would be worth $10,020 today; and if you had chosen Vanguard Short-Term Investment Grade Bond Fund, your account would be worth $10,165 today.
3. Investment Intention. If you are investing in bonds or bond funds but do not intend to take money out for at least five to ten years, you can afford to allow interest rates to move through their natural cycle. This is particularly true if you are systematically investing since as rates rise, you’ll be buying all the way up until they begin the next downward cycle. This is also true if you own individual bonds and plan to hold them until they mature. If, on the other hand, you are a retiree who is taking systematic withdrawals from your retirement funds, including your bond funds, rising rates and falling bond prices could hurt your retirement plan.
Conclusion: For more than a decade bond investors haven’t had to worry too much about their bonds. That situation, I believe, has now changed. You’ll want to take a fresh look at your bond portfolio to make sure that the credit quality and average maturity is in alignment with your short and long term financial plan. Retirees who are systematically withdrawing money to fund retirement expenses should be especially attentive to their bond holdings. Be sure that you have one good financial and debt advisor with good downtown location in your city.