No, this isn’t a scary story to be told while huddled around the orange glow of a campfire. This is, however, a story that many people have never heard before and it is one that people should listen to carefully. In the world of investments, many people have turned to bonds for one thing: safety. Most bonds have been good to them over the years because most investors haven’t lost money while investing in bonds. But all that may soon change. Unwary investors can be lulled into a false sense of security due to the past successes they’ve experienced.
What is a Bond Bear Market?
To understand a bond bear market, you must first understand something called “interest rate risk.” With bonds, you have three primary risks to consider: creditor risk, interest rate risk, and the risk of inflation eating at your returns. For this article, I’m going to concentrate on interest rate risk.
So here is what you need to know: as market interest rates go up, existing bond values go down. “What!?” you say? You didn’t think bonds could lose money? Yes, they indeed can.
Let’s explain how this works. What if you bought a bond from Widget Company of America today that is paying 2% interest. Interest rates have been super low for quite some time to help support a failing economy. So, which way do you think interest rates will go in the future? Most people would agree that they have to go up at some point; and, in fact, they have moved upward recently. Remember that 2% bond you own? What if that same bond from Widget Company of America five years from now is being issued at 4% because rates have gone up? How valuable is your 2% bond now? Think about it. If you wanted to sell your 2% bond when new bonds are paying 4% you’ll have a hard time finding a buyer won’t you? So, to sell your 2% bond, you’d have to sell it at a loss compared to what you paid for it (this is called selling at “discount”). So, can bonds lose value? You bet they can! To be fair, you could hold the bond to maturity, but you’d be stuck with a 2% bond when new bonds are paying 4%.
Let’s look at a few examples in history where bonds have lost value. In this example, I’ll show what happened to long-term government bonds:
|Year||Cap. Appr.||Income||Total Return|
|*Source 2013 Ibbotson SBBI Classic Yearbook|
What Does a Wise Investor Do?
Here is where we run into the “rock and a hard place” dilemma. We realize that bonds right now don’t offer much upside potential and there is risk of losing value as interest rates go up. At the same time, we need a place for our conservative to moderate investors to place their money to maintain safety of principal. The solution will vary depending on their personal circumstances. Here are some things that bond investors should keep in mind:
- Short Duration: Short duration bonds are less affected by interest rate hikes than long duration bonds. See those nasty losses on long term government bonds in the table we reviewed earlier? Those numbers don’t look so bad for intermediate or short-term bonds. Keep in mind though that shorter duration bonds also pay less and they are still subject to inflation risk, call risk, default risk, and other risk factors.
- Other Principal-Protected Investments: There are other types of investments out there that can offer principal protection and won’t be affected by interest rate hikes. I don’t have enough space to go through them in this article and we’d end up getting way too technical.
- Keep the Bonds: We don’t want to over-react. We don’t KNOW if and when interest rates will go up. I think bonds, even with the elevated risk of today’s environment, still play an important role in a balanced portfolio. They can still act as “shock absorbers” if we had a stock market correction.
The Bottom Line
With interest rates near historic lows, many feel they are not likely to go lower, and will eventually rise. If that happens, then outstanding bonds, particularly those with low interest rates and high durations, may experience significant price drops. People should evaluate their portfolios carefully and consider all their options. I bet you saw this coming, but my advice is to give us a call sometime to discuss your investments. If you’re a client of ours, call us to discuss your portfolio if you have concerns. If not, let us provide you with a free portfolio analysis and investment proposal.
*This article is provided for informational purposes only. It is not intended to be used as the primary basis for investment decisions, nor should it be considered as advice designed to meet the specific needs of an individual investor. The opinions expressed are solely those of the author and not of GA Repple & Co, and may not be updated as market conditions change. All investments carry risks, including the risk of losing money. Asset allocation/diversification does not guarantee a profit or protect against loss.