Why Would Anyone Invest in Bonds with Historically Low Interest Rates?
I was reading an article the other day about the risks of investing in bonds and it dawned on me that I’ve never done a newsletter explaining the risk of investing in bonds.
Bond Desk Reference Guide
I actually wrote this article and then decided I should put together a summary on bonds that advisors could read and then keep as a desk reference guide. If you are interested in my desk reference guide, click on the following link to download (it’s 19 pages):
If you are securities licensed, you should know the basics I’ll be covering, but read on anyway to learn about why you should learn more about tactically managed bond mutual fund strategies.
Bonds are a safe way to invest, right?
It’s interesting how the general public seems to have the mindset that investing in bonds is “safe.” This belief is not accurate and in today’s historically low interest rate environment, that belief is dangerous. Let me list a few bond basics:
-bond values fluctuate with interest rates. As rates rise; bond value decreases.
-longer-term bonds have more “duration.”
-longer-term bonds pay higher coupons (higher ongoing payments).
-longer-term bonds have more risk.
What is “duration”? -it’s a measure of interest rate sensitivity. For example, a 30-year maturity bond may have a duration of 20 years. So, the bond owner won’t get his money back for 30 years but when measuring the interest rate sensitivity, you would use 20 years.
Understanding duration and interest rate sensitivity-as a rule of thumb, for every 1% move in interest rates, bond value changes equals the duration. For example:
-If you have a 10-year maturity bond with an 8-year duration, if interest rates go up 1%, the value of the bond goes down 8%.
-if you have a 30-year maturity bond with a 20-year duration, if interest rates go up 1%, the value of the bond goes down 20%.
Historically low interest rates!-if it’s true that we are in a historically low interest rate environment, then why would someone invest in bonds?
Maybe because CD and money market rates are very low and clients are looking for something that will pay them a higher income payment. Unfortunately, most clients think that their full bond value will be returned to them after they are paid an income stream during the term of the bond. Is that likely to happen in today’s low interest rate environment?
Do you think that interest rates for the next 5, 10, 20, 30 years will stay where they are, will go lower (which would increase the value of bonds), or will increase (thereby decreasing the value of bonds)? Most people think interest rates will rise and maybe rise significantly over the coming years. If that happens, bond values are going to go down (and some down dramatically).
Full disclosure-for me it’s all about full disclosure to the client who then can make an informed decision. Full disclosure would include alternatives to bonds like using a tactically managed bond strategy.
Tactically managed bond strategy-first, many clients don’t know that they can invest in a bond mutual fund. This mitigates the maturity risk of owning a 5-, 10-, or 30-year bond. A mutual fund position can be liquidated at any time. The problem with bond mutual funds is that most investors will buy and hold (holding through a major downturn) or will panic sell when a downturn comes.
A better way for some clients might be to use a tactically managed bond strategy.
What is it? It’s when a tactical money manager buys, holds, sells, or shorts a bond mutual fund. The key is having tactical managers with a proven track record who have avoided large drawdown and captured upside growth when available.
www.pomplanning.net has several different tactically managed bonds (treasury as well has high yield) on its platform. Some go to cash to avoid downturns and some invest in inverse bond funds to generate positive returns when bond values are decreasing.
Roccy DeFrancesco, JD