For 30 years bond prices have been going up. And for about as long the financial press has voiced only occasional concern about their falling yields and an overdue drop in their price. But now, all you hear is worry. There isn't a business day that goes by without a forecast that interest rates will soon rise and that bonds are doomed as a consequence.
Bonds are an important part of everyone's portfolio, no matter one's age or risk tolerance. But they're even more essential for those approaching or already in retirement. Most financial advisers recommend that people in that category put at least 40 percent of their assets in bonds.
The reasoning is straightforward: The less time you have to accumulate wealth through savings, the more essential it becomes to preserve the wealth you have and have it generate income. Bonds fit that role perfectly. They generate a regular income until maturity, at which time the principal is returned to you to reinvest. And in the short-to-medium term, bonds are less likely to lose value than more volatile stocks.
But there's no free lunch in investing, and that includes bonds. Their market price is determined by buyers and sellers, and it can rise and fall in value just like stocks. When the price of a bond goes up, its yield declines. And if a bond's yield increases, that's no reason for bond holders to cheer since it means that the price of the bonds they own have fallen.
Why Bonds Haven't Fallen–Yet
Let's be clear: Interest rates probably aren't going to spike tomorrow or next month. There's not even a certainty that they will rise in the next year or two. A number of factors keep bonds from falling in price. Treasuries are still considered the safe place for capital when there's a financial crisis, and there has been no shortage of those internationally in the last five years. But the primary factor behind bond stability is the Federal Reserve.
As part of its quantitative easing program, the Fed is using numerous approaches to suppress interest rates. A primary one is the setting of the Fed funds rate. This rate, which has been at 0.25 percent since 2008, keeps other short-term interest rates low.
Another one, which was introduced in the aftermath of the 2008 credit crisis, is to purchase Treasuries and other debt, such as mortgage-backed securities, on the open market. As of May 2014, the Fed is buying $45 billion in bonds every month. By curtailing the supply, it effectively bids up their price for everyone else. That in turn reduces their yield. The Fed has been committed to owning about 40 percent of the current U.S. government debt outstanding.
So there's still some time to prepare for an interest-rate increase, at which time both those policies will come to an end. What will happen then?
If history's any guide, when the Fed raises interest rates, bond prices, particularly for bonds with longer maturity dates (10 and 30 years, for example), will initially plummet. The data, at least in the last 20 years, bear this out. In the three months following Fed fund rate hikes in 1994, 1999, and 2004, intermediate-term bonds, as measured by Ibbotson Associates, a historical financial-data provider, fell in price, resulting in a negative return for bond holders during that period. Although bonds quickly recovered in 2004, in the other two instances bond holders had a negative return for a full 12 months following the Fed rate increase.
Diversify, Diversify
So suppose it seems likely that bonds are due to fall in price. Should you abandon them altogether, and move those assets into cash or stocks? Not necessarily. First of all, as we mentioned, the anticipated rate hike is still probably at least a year away. Second, there might be an intervening crisis that postpones the economic recovery, requiring the Fed to continue to keep rates low, even beyond 2015.
But most important, diversification is still the cardinal rule in investing, no matter how inevitable it appears that one of your asset classes—in this case bonds—is bound to lose value. One solution is to make certain that within the bond portion of your portfolio, you aren't overexposed to the types that are most susceptible to a rate increase. And that would be bonds with a longer duration, which fall the most when rates rise.
Consumer Reports on the new way to buy Savings Bonds via TreasuryDirect.
Check your own bond-fund holdings on such websites as Morningstar.com to see how the firms categorize your holdings. In most cases they will fall in one of three classes: short duration, intermediate duration, and long duration. Long-duration bond funds are of course those most susceptible to rate increases. And intermediate funds will have a downside, too. But short-term bond funds will lose the least amount of money, if any.
There's another reason you should, for the time being, avoid long-term Treasury bonds. After a 30-year bond bull market, there's little upside left. Unlike stocks, which theoretically can double and redouble in price, bond prices are constrained by yield, which can't fall below zero. Treasury prices are already at record lows; with the 10-year Treasury yielding just 2.6 percent in May 2014, there's little chance for additional gains.
In the unlikely and unprecedented event that the 10-year Treasury bond yield falls to 1.6 percent, holders of those bonds would record a 9 percent gain. On the other hand, if the 10-year bond yield climbs to 3.6 percent, a level it was at only three years ago, you would lose 9 percent. By comparison, holders of shorter-term five-year Treasuries would lose only 3.7 percent, and two-year Treasuries 0.5 percent.
Our advice? Stay diversified in the bond portion of your portfolio, but wade in the shallow end of the pool. Some of the more inexpensive shorter-term bond funds, including exchange-traded funds such as the Vanguard Short-Term Bond ETF (ticker BSV), offer similar yields without as much exposure to the more vulnerable intermediate and long-term bonds.
This article appeared in Consumer Reports Money Adviser.
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