The economic recovery has been gaining traction as evidenced by improvements in two important areas: job growth and housing. Investors who fled the equity markets in a panic during the 2008-09 financial meltdown are feeling more confident and have driven the major stock indexes to near all-time highs. If things seem to be looking up, why are bond investors so worried?
The prevailing concern expressed by many respected investment experts and fueled by the media, is that with the economy picking up steam and interest rates near historic lows, the Fed may begin to nudge rates up to stave off future inflation and that could spell trouble for bonds. The concern is valid because, while many factors influence the value of a bond portfolio, changes in interest rates are often the primary driver of both bond prices and performance.
Basic bond math dictates that prices move inversely with changes in interest rates. When rates rise, bond prices fall and vice versa. Investors have already gotten a taste of the impact that rising rates have on their bond investments. Interest rates climbed during the second quarter of this year inflicting some damage on virtually all bond fund categories and especially on inflation-protected securities and foreign bonds.
So, just as the steadily declining interest rates over the last 30 years have driven up bond values, future rate increases will likely depress them. This means that investors today face a bond market that presents an increased risk of loss and a decreased opportunity for returns.
This may suggest that investors should steer clear of bonds or at least make dramatic changes to the types of fixed income investments they own. Be aware, however, that predicting interest rate changes and their specific effects is notoriously difficult. Although many in the financial advice business have been predicting rising interest rates and falling bond prices for years, these forecasts have not yet materialized. Before making major changes to a bond portfolio, investors should take into account three important considerations.
First, returns from bond fund investments come from two sources: interest payments paid out as dividends to fund investors and changes in price. Over time interest payments typically contribute much more to returns than do changes in price. Therefore when evaluating the impact of rate changes on your investments, recognize that while a rise in rates will cause bond prices to fall in the short-term, the reinvestment of the interest payments into the new higher-yielding bonds and the compounding of those reinvested payments can boost returns over the long-term. This means that over time, the higher yields on the new bonds can more than offset the lower values on existing bonds.
Second, successful investors understand the role and the risk/return characteristics of each investment they own. It’s no surprise we are getting bombarded by the financial industry and the media about steps that investors can take to blunt the impact of rising rates. The recommendations run the gamut from shifting the portfolio to bond funds that invest in shorter duration, non-US and lower credit quality securities.
While each of these may help to increase yields and temper short-term bond fund losses, they all carry additional risks when compared to high-quality bond funds that provide powerful diversification benefits to investor portfolios. In times of financial crisis when investors dump all other asset classes, high-quality (especially U.S. Treasury) bonds often provide the only protection from stomach-churning market declines like the one we experienced a few years ago. Abandoning bonds now in anticipation of future rate increases would leave little protection when the equity markets experience the next painful downturn.
Third, a rise in interest rates can affect all assets, not just bonds. Though economic and geopolitical forces can affect prices of different assets differently, rising interest rates generally affect all assets negatively. Investments including stocks and bonds are valued based upon their expected return (from future dividends/interest and price appreciation) relative to interest rates.
If the general level of interest rates rise, the value of that expected return is worth less by comparison and therefore the price that investors are willing to pay for that asset declines. The point is investors need to be careful not to jump from the frying pan (high-quality bonds) into the fire (stocks and other risky assets) by sinking money into an investment they expect will be unaffected in a rising rate environment.
Inevitably, some will react to the headlines of a pending bond market collapse. They will abandon high-quality bonds and be lured into other investments being touted by those having a vested financial interest (but no financial risk) in recommending them. Rather than risking hard-earned money based on Wall Street’s latest prediction, investors might be better served by lowering expectations for future bond returns and adjusting their saving and spending plans accordingly. Assuming that you have a well thought out investment plan and your goals have not changed, high-quality bonds still deserve a prominent place in most portfolios.
John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com.
This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.