Investors who are wondering when it’s safe to get back into bonds have one thing going for them: They recognize a real risk that many don’t.
But the question still heads down the wrong path. Generalizations about the timing of getting into and out of asset classes are rarely accurate, and they distract from the more productive goal of focusing on what you can do to maintain your long-term financial health. The answers to several other questions about bonds, however, may help in determining an appropriate investment strategy to meet your goals.
Before we talk about the state of the bond market, it is important to discuss what a bond is and what it does. Although there are some technical differences, it is easiest to think of a bond as a tradable loan. Bonds are obligations of the issuer, acting as a borrower, to repay a certain sum with interest to the lender, or bondholder. Bonds are generally issued with a $1,000 “par” or face value, and the bond’s stated interest rate is the total annual interest payments divided by that initial value of the bond. If a bond pays $50 of interest per year on an initial $1,000 investment, the interest rate will be stated as 5 percent.
Simple enough. But once the bonds are issued, the current price or “principal” value, of the bond may change because of a variety of factors. Among these are the overall level of interest rates available in the market, the issuer’s perceived creditworthiness, the expected inflation rate, the amount of time left until the bond’s maturity, investors’ general appetite for risk, and supply and demand for the particular bond.
Though bonds are typically perceived as safer investments than stocks, the reality is slightly more complex. Once bonds trade on the open market, an individual company’s bonds will not always be safer than its stocks. Both stock and bond prices fluctuate; the relative risk of an investment is largely a factor of its price. If all types of markets were completely efficient, it is true that a bond would always be safer than a stock. In reality, this is not always the case. It’s also entirely possible that a stock of one company may be safer than a bond issued by a different company.
The reason a bond investment is perceived as safer than a stock investment is that bondholders are ranked more highly than shareholders in the capital structure of an organization. Bondholders are therefore more likely to be repaid in the event of a bankruptcy or default. Since investors want to be compensated with added return for taking on additional risk, stocks should be priced to provide higher returns than bonds in accordance with this higher risk. As a result, the long-term expected returns in the stock market are generally higher than the expected return of bonds. Historical data have borne out this theory, and few dispute it. Given this information, an investor looking to maximize his or her returns might think that bonds are only for the faint of heart.
Why Invest In Bonds?
Even an aggressive investor should pay some attention to bonds. One benefit of bonds is that they have a low or negative correlation with stocks. This means that when stocks have a bad year, bonds as a whole do well; they “zag” when stocks “zig.” In every calendar year since 1977 in which large U.S. stocks have had negative returns, the bond market has had positive returns of at least 3 percent.
Bonds also have a higher likelihood of preserving the dollar value of an investment over short periods of time, since the annual return on stocks is highly volatile. However, over longer periods of 10 years or more, well-diversified stocks virtually guarantee investors a positive return. If an investor will need to withdraw money from his or her portfolio within the next five years, conservative bonds are a sensible option.
Even if you are not going to withdraw from your portfolio, conservative bonds provide an option on the future. In a downturn, you can redeploy the preserved capital into assets that have effectively gone on sale during the market decline. Bonds in a portfolio reduce volatility, cover short-term cash needs and preserve “dry powder” to deploy opportunistically in a market downturn. These are all sensible uses. On the other hand, overinvesting in bonds can pose more risks than investors may realize.
What Are The Risks Of Bonds?
Imagine bonds’ current values and interest rates sitting on opposite sides of a seesaw. When interest rates go up, bond prices go down. The magnitude of the decrease in bond values increases as the bond’s duration increases. For every 1 percent change in interest rates, a bond’s value can be expected to change in the opposite direction by a percentage equal to the bond’s duration. For example, if the market interest rate on a bond with a two-year duration increases to 1.3 percent from 0.3 percent, the bonds should decrease in value by 2 percent. If rates normalize to the historical average of 4.2 percent, the two-year bond should decrease in value by about 7.8 percent.
While such negative returns are not appealing, they are not unmanageable, either. However, longer-term bonds pose the true risk. If interest rates on a 10-year duration bond increased by the same 4 percent, the current value of the bond would decrease by 40 percent. Interest rates are still not far from historic lows, but at some point they are bound to normalize. This makes long-term bonds in particular very risky at this time. Bonds are often referred to as fixed-income investments, but it is important to recognize that they provide a fixed cash flow, not a fixed return. Some bonds may now provide nearly return-free risk.
Another major risk of overinvesting in bonds is that, although they work well to satisfy short-term cash needs, they can destroy wealth in the long term. You can guarantee yourself close to a 3 percent annual return by buying a 10-year Treasury note today. The downside is that if inflation is 4 percent over the same time period, you are guaranteed to lose about 10 percent of your purchasing power over that time, even though the dollar balance on your account will grow. If inflation is at 6 percent, your purchasing power will decrease by more than 25 percent. Conservative bonds have historically struggled to keep up with inflation, and today’s low interest rates mean that most bond investments will likely lose the race. Having a traditionally “conservative” asset allocation of 100 percent bonds would actually be riskier than a more balanced portfolio.
The Federal Reserve’s decision to maintain low interest rates for an extended period was meant to spur investment and the broader economy, but it comes at the expense of conservative investors. In the face of low interest rates, many risk-averse investors have moved to riskier areas of the bond market in search of higher incomes, rather than changing their overall investment approaches in a more disciplined, balanced way.
Risk in fixed income comes in a few primary varieties: credit risk, interest rate risk, currency risk and liquidity risk. Some investors have shifted their investments to bonds from lower-quality issuers to earn more income. This strategy can backfire if the company’s ability to meet its obligations decreases. Longer-term bonds also pay higher incomes than their shorter-term counterparts, but will lose substantial value if interest rates or inflation rise. Foreign bonds might have higher interest rates than domestic bonds, but the return will ultimately depend on both the interest rates and the changes in currency exchange rates, which are hard to predict. Bondholders might also be able to generate more income by finding an obscure bond issuer. However, if the bond owner needs to sell the bond before its maturity, he or she may need to do so at a large discount if the bonds are thinly traded.
The growing list of municipalities that have defaulted on bonds serves as a reminder that issuer-specific risk should be a real concern for all bond investors. Even companies with good credit ratings experience unexpected events that impair their ability to repay.
Taking on more risk in a bond portfolio is not inherently a poor strategy. The problem with it today is that the price of riskier fixed-income investments has been driven up by so many investors pursuing the same strategy. Given how many investors are hungry for increased income, taking on additional risk in bonds is likely not worth the increased return.
Given The Risks, What Do We Suggest?
We recommend that investors focus on maximizing the total return of their portfolios over the long term, rather than trying to maximize current income in today’s low interest rate environment. We have been wary of the risk of a bond market collapse because of rising interest rates for a long time, and have positioned our clients’ portfolios accordingly. But that does not mean avoiding fixed-income investments altogether.
While it may be counterintuitive to think that adding equities can actually decrease risk, based on historical returns, adding some equity exposure to a bond portfolio provides the proverbial free lunch – higher return with less risk. For individuals and families who are investing for the long term, the most significant risk is that changed circumstances or a severe market decline might prompt them to liquidate their holdings at an inopportune time. This would make it unlikely that they could achieve the expected long-term returns of a given asset allocation. Therefore, it is important that investors develop an approach that balances risks, but they must also understand and accept the inherent volatility that accompanies a growth-oriented portfolio.
Conservative investments are meant to preserve capital. Therefore, we continue to recommend that clients invest the majority of their fixed-income allocations in low-yield, safe investments that should not be too adversely affected by rising interest rates. Such securities may include money market funds, short-term corporate and municipal bonds, floating-rate loan funds and funds pursuing absolute return strategies. Although these investments will earn less in the short term than a riskier bond portfolio, rising rates will not hurt their principal value as much. Therefore, more capital will be available to reinvest at higher interest rates.
Investors should also achieve some tax savings by focusing on total return rather than on generating income, as long-term capital gains realized from the sale of appreciated positions will receive more favorable tax treatment than will interest income that is subject to ordinary income tax rates. Moreover, focusing on total return will also mitigate exposure to the new tax on net investment income.
So When Is It Safe To Get Back Into Bonds?
Despite my initial claim that this is not the best question to ask, I will give you an answer. Once bond yields begin to approach their historical averages, we will recommend that investors move certain assets into longer duration fixed-income securities. But you cannot wait for the Federal Reserve to change interest rates. Like any other market, values in the bond market change based on people’s expectations of the future. Even in normal interest rate environments, however, we typically advise clients that the majority of their fixed-income allocation be invested in short- and intermediate-term bonds. Bonds are for protecting your wealth, not for risking it.