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William J. Lynott A Word of Caution for Bond Investors
F you have followed con- ventional advice on diversi- fication over the past de- cade, you have a portion of your portfolio invested in bonds of vari- ous types. And that has probably served you well. When the stock market tanked in mid-2008, many investors were spared the worst of it by strong returns from their fixed-income investments. Most professionals still recommend an asset mix that includes fixed in- come investments as an essen- tial part of every portfolio. But an increasing number of pros are sounding messages of caution for those investors who have a significant portion of their portfolios invested in bonds. Many people have not yet rec- ognized the increasing risks in the bond market. While it’s not likely that there will be a decline in bond prices that comes close to the crash in stock prices in 2008, it does seem likely that the overall return on bonds in the near future will be far more modest than in recent years. Even the possibility of negative returns can’t be ruled out. Perhaps the most important role that bonds play in an invest- ment portfolio is a reduction in volatility. Because the price of bonds tends to move in the op- posite direction of stock prices but not as sharply as stock prices, a balanced portfolio is less likely to suffer dramatic ups
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and downs in volatile markets. Of course, this means that when stocks rise dramatically, as they have during the past year, bond prices tend to decline.
Interest Rate Impact
The prime mover in bond prices is the interest rate, which tends to rise when stock prices rise. With interest rates at his- torically low levels, it is unlikely that they will go lower. There is nowhere for them to go but up, and when interest rates go up, the price of bonds goes down. When that happens, the result is a decrease in market value. If interest rates were to move sharply higher, the value of bonds could even depreciate enough to completely offset in- terest payments, resulting in a negative total return. That dark scenario has happened in the past, and it can’t be ruled out in the future, though it is unlikely. Whether inflation and interest rates are poised for a rapid rise cannot be known for sure, but there are signs pointing in that direction. I do not believe the doomsayers who are predicting rampant inflation, but I do feel that some degree of inflation is inevitable over the coming months, and with inflation comes a drop in bond prices.
In assessing these risks, it’s important to know what you ex- pect from the bonds you own.
That will help you determine what percentage of your portfolio should be invested in them. In general, the return on bonds comes in two parts. One is the yield (the stated interest rate). The other is the appreciation or depreciation in the principal, or the price you would receive if you were to sell the bond. When the yield declines, as it has been doing in recent years, the princi- pal rises, which produces a com- fortable overall return. The prob- lem is that with historically low interest rates such as those we are experiencing now, there is little if any room for future princi- pal appreciation, as interest rates aren’t likely to go lower.
Two Types of Investors Some investors in bonds are traders; they look for principal appreciation, or an increase in the bonds’ market value result- ing in capital gains. It is these investors who need to be aware of the current dynamics in the marketplace. With interest rates so low and bond prices corre- spondingly high, there is little chance of capital appreciation in the foreseeable future. So, if you invest in bonds as a possible source of capital gains, you may want to review your position. Other bond buyers are better described as buy-and-hold inves- tors. Many retirees, for example, invest in bonds as a source of a
fixed and predictable income. The interest payment on bonds remains fixed regardless of fluc- tuations in their market price. For these buyers, paper losses or gains are of little concern since they intend to hold on to their investments without regard to changes in market price. Of course, there are risks even for buy-and-hold bond investors. Although bond defaults are rela- tively rare, they can and do hap- pen. That’s why bond holders need to keep a watchful eye on the fiscal condition of issuers, whether corporate or municipal. None of this is to suggest that you should avoid investing in bonds completely. Virtually all fi- nancial professionals agree that bonds and bond funds have a place in nearly every investor’s portfolio, along with stocks and other investments. The challenge is to make sure that your alloca- tion of bonds makes sense given your personal objectives and to remain aware that every form of investment, including bonds, car- ries an element of risk.
Remember, too, that past per-
formance is no guarantee of fu- ture performance. Over the past decade or so, stocks have pro- vided little or no overall return while we’ve enjoyed very high returns on bonds over the last several years. Assuming that this performance will be repeated could be a big mistake. ■
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