Bond investors should be preparing for volatility
Long-term rally could be coming to an end soon
Michael MaehlJune 19th, 2014
For the last 30-plus years, it hasn’t particularly mattered whether you owned bond funds or individual bonds. Helped by falling interest rates, they both delivered consistent income and a counterbalance to stock market volatility.
But, with higher rates on the horizon and the Federal Reserve reducing the pace of its quantitative easing measures, investors are about to get schooled in just how volatile these kinds of securities can be. For investors who have experienced only a bond market rally, this promises to be quite an eye-opener.
Conventional wisdom, a term that market action often twists into an oxymoron, has long held that bonds should become a much more significant part of your investment holdings as you enter into retirement and certainly thereafter.
I submit that, from my perspective of over 40 years in financial services, this can be a mistake for many investors. Holding to this perception can bring major harm to your retirement assets, or at least reduce the ability of your retirement savings to provide you with sustained withdrawals over long periods.
I say this because markets for all investments, even those for bonds, are both cyclical and inexorable. When the cycles actually begin and end is always unknown. However, the effect of the changing cycles is not, and that’s what I want to bring to your attention.
When I began my career in 1973, the return on the 10-year Treasury note was about 6.5 percent. Inflation during the following few years caused the 10-year rate to peak at 16.5 percent in September 1981. It was then that the bull market in bonds began.
In August 2012, the 10-year rate bottomed at just under 1 percent, according to the U.S. Department of Treasury. This long-term drop in rates has created a whole generation of investors who’ve become conditioned to believe that bonds “always” maintain their price, making them—in those folks’ eyes—comparatively safe. That’s because, as interest rates drop, bonds tend to be steady or even rise in value. So far, these past couple of transition years haven’t given the investors any real cause for alarm as rates have been kept low to help the recovery gain traction.
With rates having dropped during these past 30-some years, investors have never really thought of volatility in price when considering bonds. However, if you check the record, you’ll see that from 1946 up until 1981, bonds provided negative inflation-adjusted returns.
Now we’re coming to the other side of an interest-rate cycle, as in when rates rise. Bond prices won’t be treated in such a friendly manner. That’s because, as the rates rise, prices of existing bonds tend to drop. This has nothing to do with credit quality—all bonds react the same. While bonds coming due within a short period of time aren’t affected as much by rate changes, those with maturity dates out 10 years or more tend to react more noticeably—getting the whole effect—up or down.
Here’s an example of what I mean. A $300,000 investment in a fixed-income mutual fund with an average maturity of 20 years (made up of a mix of 10-, 20- and 30-year bonds), for example, could fall to $260,000 if interest rates climb just 1 percentage point. That’s a loss of 13 percent of principal.
If you know someone who is invested heavily in bonds, there’s an additional challenge they face, even more than price risk. It’s called purchasing power risk, or, put somewhat less delicately: Which will expire first—them or their money?
According to the Department of Labor, during the past 80 years, here in the U.S., we’ve averaged an annual inflation rate of 3 percent. The conclusion is that, in order to have your dollar buy you the same amount of “stuff” at some future time, your asset pool must grow at least 3 percent per year—just to stay even. You also should factor in taxes on your portfolio results to get your net real return.
So, what investments would have provided you returns that offer the opportunity to grow your assets so your net real return is positive? My buddies at DALBAR provided these 20-year annualized returns of various asset classes. This period saw the housing bubble, the nominal high for gold, two stock market tops and lots of other interesting events. According to their figures, gold had an 8.4 percent return, the S&P 500 (dividends not reinvested) showed 8.2 percent, bonds were 6.3 percent, and private homes were up 2.7 percent. The inflation rate over the period was 2.5 percent.
Most bond investors use bond funds instead of individual issues. Many of them mistakenly believe the diversification inherent in those funds makes them more insulated from market forces. That’s not the case. Also according to DALBAR, bond fund investors, reacting emotionally to news and current events, did even worse during the past 20 years. Their average annual return over that time was only 0.7 percent.
Here’s the tactical situation.
You’re facing a long period of time with a generally finite pool of money to support you. Interest rates are set to rise, whether due to improved economics or increased demand for funds. Inflation is starting to pick up and somehow you have a bunch of your assets in investments that have low fixed returns. This can subject you to large additional risk of principal as rates rise, as well as reduction of your future buying power.
To help counter this, especially for those with a longer time horizon for your investing, I suggest you consider swapping out of much of your bond assets while the prices are still relatively good. Move them into high-quality stocks (or funds made up of same) with a history of increasing dividend payouts. High-yield bonds, which are more sensitive to the economy than to interest rates, could also take a portion. Senior bank loans, convertible bonds, as well as select midstream master limited partnerships and real estate investment trusts can help maintain or even perhaps improve your total return.
Bonds remain an important part of a strong asset allocation strategy. However, given the current and long-term realities of the coming rate changes, I don’t believe they should always be the largest part for every retiree.
Michael Maehl is an independent financial adviser and Spokane-based senior vice president of Opus 111 Group LLC, a Seattle-based financial services company. He can be reached at 509.747.3323 or firstname.lastname@example.org.