Historically, bonds have provided an anchor for most investors’ portfolios. We have all been told that as you get older, you should put more of your money in bonds and less in stocks. The Barclays U.S. 10+ Year Corporate Bond Index has returned an average of 7.17 percent annually over the past 10 years. These returns have helped retirees earn a steady “paycheck,” with less concern about the volatile market. However, the days of putting the bulk of your money into bonds or bond funds and leaving your portfolio on autopilot are over. As the Federal Reserve begins to normalize their monetary policy, by raising rates, bond investors could lose a lot of their nest egg.
The coupon payments offered by bonds are determined by the underlying interest rate. Today, if you loan the U.S. government $10,000 for 10 years, through a 10-year bond, they promise to pay you a little over $200 in interest each year (2 percent) until they return the full $10,000 after the 10th year. The risk of rising interest rates becomes an issue, as a new bond investor has the ability to earn more than $200 per year by simply buying the newest bond offering. When this happens, the investor holding the 2 percent bond may have less value than the bond investor holding a 4 percent bond, for example (which pays $400 per year). And that’s why when interest rates go up, bond prices go down.
Investors who are holding long-term bonds (those that mature in over 10 years) are most at risk from rising interest rates. This is true because the longer the term, the higher the potential loss from a change in interest rates. Another bond investor at significant risk is one that holds bond funds. The reason: The “actual” bond has a stated maturity date, while the bond fund has no maturity. So, if the actual bondholder keeps the bond to maturity, he or she will get his or her interest payments and the principal back after 10 years.
The holder of a bond fund does not have that option. Depending on what the fund manager is doing, he or she could either do well (not likely) or lose a significant amount of money in what he or she thought was a safe investment. The Fed announced on Dec. 17 that they will “be patient” to raise interest rates. Investors still have time to make adjustments to their portfolios to limit their downside risk. In order to assess which investments stand to lose the most when rates rise, review your bond portfolio while keeping in mind the following:
What is your bonds maturity? The longer you have to wait to have your bond principal back, the more you stand to lose when rates increase. That’s because the interest rates of traditional bonds are fixed, and don’t change over their lifetime. Consider that on Jan. 1, 1984, the U.S. 10-year government bond rate was 11.67 percent. Today, the 10-year U.S. government bond yields about 2 percent.
Therefore, investors would pay a premium to get that 11.6 percent return if it were available (and it is not just in case you were looking.) A premium could be defined as the additional money someone is willing to pay to get the higher rate. Let’s say they would pay $12,000 for a $10,000 bond. The $2,000 is the premium. Paying a premium for this bond may still put the investor in a better position than if he were to buy the $10,000 bond that only pays 2.0 percent.
As rates increase, bondholders of long-maturity bonds will have to discount their bonds below their initial investment in order to sell them (if they would like to sell them before the maturity date). The higher rates increase, the bigger the discount they will have to take to sell. Understanding when you will get your money back gives you a better understanding of what type of risk your bonds hold. A financial advisor can help determine the duration of your positions and give an estimate of what your loss will likely be as interest rates rise.
What bond risk do I have in mutual funds? Mutual funds, including life-cycle funds, are at greater risk for loss when rates increase. Mutual funds may be forced to keep a particular duration (say 10 years) to meet a fund’s investment objective. When interest rates increase, it will cause the duration of bonds to decrease, because it will take less time to pay back the initial investment at a higher interest rate. The fund manager could be forced to sell the existing bonds at a discount, not only because he or she can fulfill his or her mandate with higher yielding bonds, but also because the fund objectives force him or her to buy the best bonds available at that time. The fund manager selling at a discount could result in you taking a loss in your shares.
Potentially lower your interest rate risk in bond or life-cycle funds by opting for funds with shorter maturities. Many of these funds will hold bonds that mature in under 10 years (or five years). This limits your downside risk because short-duration funds are not as sensitive to changes in interest rates.
We are at a historical point within the bond market, as we muddle through the low interest rate environment. The ramifications of rising interest rates will be significant for individuals holding long-term bonds and bond funds. Investors who are proactive in understanding what kinds of bonds they have and why they have them in their portfolios, will have greater success than those who do not. Keep an eye on the Fed’s policies and keep open communication with your investment advisor throughout this significant transition.
If you are retired or about to retire, be especially careful, as the bonds you thought were safe, may not be.
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Have Bonds Lost Their Safety? originally appeared on usnews.com
