High Anxiety

In today’s volatile market, I find it interesting that lately clients are showing higher anxiety about their bond holdings than about the stock market. They hear that interest rates “have to rise” and bond values “will get hammered” as a result. The logical inference from these ominous warnings is to avoid bonds, but there are some problems with such thinking.

The media and some professional advisors have a tendency to create a story by taking a kernel of truth and blowing it out of proportion. Please consider that even a very bad scenario for interest rates does not warrant such concern. A 5% loss would be considered a disastrous year for bonds. In contrast, we all know that stocks can lose 50% in a fairly short period of time.

The underlying truth is that there is an inverse relationship between interest rates and bond values. When the prevailing interest rate for a certain type of bond rises, the bond that you own of the same type (with a lower interest rate) will be less attractive. If you want to sell it, why would someone pay the same price that you did if they can get a similar bond that pays more income?

The answer to this scenario is that they would only buy yours if you offer to discount the price of your bond. The buyer would be enticed to buy your bond, even though it has lower interest payments, because the lower price makes the yield the same as the newer bonds.

For example, if you paid $1,000 for a bond with five years until maturity that paid $40 per year in interest, you would have a yield-to-maturity of 4%. If similar bonds were suddenly offered at 5% (paying $50 per year) your bond would only be worth about $950. The market resets your bond to the prevailing 5% yield by dropping the market value. In fact, bonds across the entire market are constantly adjusted, so that all bonds of the same type and risk have the same yield-to-maturity. Keep in mind, though, that if you hold your bond until maturity, as long as the issuer doesn’t default, you will receive the full $1,000 back and earn the 4% that you were promised.

Another issue is that while the forecast for higher interest rates might come true, we don’t know for sure it will happen. Timing interest rates is just as futile as timing the stock market. Even if it does happen, we don’t know when and/or how rapidly it will occur. People have been talking about rates rising for the last couple of years – but rates still haven’t yet. During this same period, those who have waited with cash-in-hand have given up any interest income they could have made.

Bond wary investors should also consider the alternatives. Stocks are much more volatile than bonds, and commodities are even more unpredictable than stocks. Cash and short-term accounts could immunize a portfolio somewhat from adverse interest rate moves, but unfortunately these options are paying virtually no interest.

So far, I have deliberately focused on individual bonds rather than bond mutual funds to better illustrate the dynamics. While there are some differences between using individual bonds and funds, a bond fund is just a collection of individual bonds – so the same concepts mostly apply.

In a rising rate environment, your account statement would show that your bond fund’s Net Asset Value (NAV) has declined. Even so, the fund would continue to earn the same interest and make distributions to the shareholders, which is the main reason you bought the fund in the first place. A loss would only be realized, if you sell your shares soon after purchase. The higher interest rates on the bonds, added to the fund as others mature, cushion the initial setback on the fund’s NAV and offset the loss within a short period of time. A negative year is rare with high quality bonds. After a few years, they invariably provide a positive return. If you stay the course, a change in interest rates will not have a major impact on your portfolio.

That said, my concern is that the current focus on the short-term direction of interest rates will obscure the real story, which is the long-term expectation from bonds. It’s almost a certainty that the return from bonds will be very low in the years ahead regardless of what happens with interest rates. Studies show that the expected future return from bonds is very close to the yield when they were purchased. Since interest rates have been so low for several years, you can be confident that your bond portfolio will have a paltry return in the years ahead.

Investors can get into trouble by looking at historical rates of return to help them choose investments without understanding the underlying factors that drive performance of a particular asset class. For example, 401(k) participants are often presented with a 10-year performance history table of the mutual fund options in the plan. The bond funds will look very attractive compared to the stock funds because the past returns from bonds are inflated by higher interest rates years ago, which will not be achievable going forward. Similarly, investors might avoid the stock funds, which suffered very poor returns in recent years, even though they are likely to do much better in the future.

While the near-term will not be the disaster some people think, it will not be very good either. This combined with the poor outlook going forward does not make a strong case for owning bonds. Nevertheless, even if they are not particularly attractive investments at this time, almost all investors should have a healthy amount of bond exposure in the portfolio. Investors need to remember the purpose of bonds in the portfolio. Bonds provide diversification away from the riskier asset classes like stocks. They also provide a source of stable funds for rebalancing to take advantage of opportunities when the prices of other assets decline and become bargains.

These days, I can understand why some investors are a little more anxious about their bond holdings, but it is important for them to keep a proper perspective. Bonds serve a necessary purpose for your portfolio and will provide a positive return over a reasonable holding period. When it comes to your investments, there are many more important things to worry about.