Should You Avoid Bonds in Today’s Environment?

Should You Avoid Bonds in Today’s Environment?

FINRA, the Financial Industry Regulatory Authority, recently warned investors that in the event of rising interest rates, “outstanding bonds, particularly those with a low interest rate and high duration may experience significant price drops.” Why are bonds facing this risk today and what should investors do as a result?

As I wrote last year, we are on the verge of a long period of rising interest rates. At the moment rates are not moving because the federal government had been artificially keeping them low to stimulate economic growth. But this situation will not last forever. And when interest rates increase, bond prices decrease proportionally. Think about it: suppose you bought a bond for $1,000 paying 5% interest (that is, $50 per year), and two years later interest rates doubled to 10%. What would your bond now be worth? Certainly not $1,000. Who would pay $1,000 for a bond paying $50 per year, or 5%, when they can get another $1,000 bond paying $100 per year (10%)? If you wanted to sell your bond, all you’d be able to get for it is $500 (which, at $50 per year, would be yielding an equivalent 10%). You’ve just lost half the value of your bond!

Does this mean that investors should heed FINRA’s warning and avoid bonds?

Not so fast, argues Joel Dickson, a senior investment strategist at Vanguard Group Inc. “It’s not clear that rising interest rates are detrimental to long-term returns,” he said in an interview at IndexUniverse’s Inside ETFs Conference. While rising interest rates might result in immediate losses, over a longer time frame the benefits of reinvesting at higher rates could offset the short-term losses. In fact, research by the Brandes Institute supports that view. They looked at bond returns over each five-year period beginning in 1926 through 2011, and found that over 85% of the returns over each of the five-year periods on average were due to income (that is, the interest payments) versus capital gains (bond price changes). The results suggest that in a rising rate environment there’s a real benefit in being able to recycle older lower-yielding bonds into newer higher yielding ones, similar to the way most bond mutual funds work.

Note also that FINRA’s warning specifically addressed higher duration bonds. Duration is a measure of how sensitive a bond’s price is to changing interest rates, and is to some extent determined by bond maturity. Shorter-term bonds (those with maturities less than five years) would be affected much less severely than longer-term bonds in a rising rate environment. And you can actually calculate the impact. For example, a bond fund with ten-year duration will decrease in value by 10% if interest rates rise by one percentage point. You can find measures of duration in a fund’s fact sheet or on Morningstar.com.

There are also many different types of bonds from which you can choose to invest, each with its own risks and rewards. There are even Treasury Inflation-Protected Securities, or TIPS, whose prices adjust not only negatively with increases in prevailing interest rates but also positively at the same time as inflation heats up.

Although it’s common to fear short-term bond losses, investors might find themselves in trouble if they don’t keep to a long-term plan. “The behavioral reaction to the short-term losses is the real risk,” Dickson said. “There’s the potential to make things worse by selling and locking in the loss.” Indeed, how many people panicked in late 2008 and sold all their stocks, only to miss out on the subsequent rally as the economy healed?

Keep in mind that although interest rates are expected to rise over the long term, the path is far from smooth. Leuthold Research looked at bond returns from 1946 through 1981, the last period of rising interest rates. Although bonds had negative returns in 15 out of those 35 years, returns were positive in the other 20, and were double-digit positive in five of them. Given the importance of bonds in a well-diversified portfolio, the message is that you should not avoid them, but (for the next 30 years or so) be very selective about your choices.

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