By Chris L. Meacham, CPA
We all imagined the day would come, and finally, it did.
When the Fed announced that it may stop its bond-buying program, investors countered with a knee-jerk reaction, causing interest rates to rise while bringing bond prices to its knees for the first time in decades.
As investors already know, when interest rates rise on bond assets, the value of the bond consequently goes down. So when bonds began experiencing volatility and losing value in the face of rising rates, investors began to panic.
But the current state of affairs must be put into context. Before you react, you must understand bonds and the market’s future. Let’s take a look at four essential principles every investor needs to know when it comes to bond investments.
Although the initial reaction is to agonize over losses, it isn’t sensible when you compare the performance of bonds against other investments.
Understand that although this may not be the year for bonds, it isn’t the worst thing that can happen to a portfolio. This year, bonds have been down by 3 percent, but compare that to stocks that can plummet as much as 40 percent annually. In context, bonds are -- for many portfolios -- a necessary evil for now.
The bond market is undoubtedly experiencing volatility in its current state. Investors are understandably concerned about whether bonds will continue to decline in today’s uncertain market. Again, let’s defer to context and historical rates to understand future volatility. According to JP Morgan, 10-year U.S. Treasury rates haven’t exceeded 4 percent above the Federal Funds Rate. It is unlikely that the Fed will raise its Fund Rate this year or in 2014, so interest rates should not increase dramatically if we’re to look at historical data. That means bonds are not likely to destroy a portfolio based on future estimates.
When a bond has a higher duration, it will be more sensitive to rising interest rates. A simple way to understand duration is to think of it as the length of time before you benefit from any interest rate increase. For example, if your bond portfolio has a duration of 3 years and interest rates rise, it will take you 3 years before you benefit from the increased bond rates. Portfolios with higher duration therefore have to wait longer before the increased rates are beneficial. That is why many bond managers have talked about lowering the duration of their portfolios with the expectation of higher rates in the near future. But if interest rates remain stable or increase minimally, investments that rely on bonds could still break even in the face of interest income earned on-going. Act prudently and with the advice of a financial advisor if you seek to move investments elsewhere – often times, when all factors are considered, and the numbers are crunched, you may be better off keeping bonds in your portfolio.
Investors should not inherently worry about portfolios that have bonds given that an investment strategy is in place. For the most part, bonds generate income and act as cushions to higher volatility instruments like stocks. Take a look at your duration, and see how it fits with your investment objectives. It is important that you pre-plan your strategy when it comes to keeping bonds or moving money.
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The information contained in this article is believed to be accurate. However, Cornerstone makes no claim regarding its accuracy, completeness, or reliability, and the information is not intended to be used as the sole basis in making any investment decisions and is no substitution to consulting with a licensed professional about your specific situation. This information does not constitute tax or legal advice, and should not be relied upon for such purposes.