Are Bonds Sure-Fire Losers?

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Are Bonds Sure-Fire Losers?

Everyone today seems to be an expert on the bond market. Typical viewpoints include;

“Interest Rates have nowhere to go but up!”

“When Interest Rates Go Up Bond Investors Lose Money!”

“Bond Investors are in for a Rude Awakening!”

 

That last one is especially sweet. Do you mean there is someone out there who owns bonds and hasn’t heard that rising interest rates are bad for bonds? Really?

 

Yes there is a mathematically grounded inverse relationship between bond prices and bond yields. When rates go up, prices go down and vice versa. And yes it is highly likely that the interest rates will go up at some point in the future. (We had previously suggested that investors move some of their fixed income into liquid alternative investments).

 

However, it is also a fact that interest rates have already gone up as a result of both Fed Chairman Bernanke’s statements and our collective hand-wringing. And we have recently been informed by Mr. Bernanke that he is not yet ready, contrary to previous loud hints, to begin unwinding his massive easing program. As we gaze at our old friend the Yield Curve, we see that some bond yields have gone up more than others. For example, the yield on the 10 year US Treasury has increased 100 basis points since the low reached in May, while the yield on the 7 Year has increased 93 basis points. The 5 Year US Treasury has increased 75 basis points, while the 3 year went up 36 basis points and the 2 Year has increased just 15 basis points. Why did long bonds increase more than short bonds? Because long term bonds inherently carry more interest rate risk and investors demand more of a risk premium. And because long bonds are less under the spell of the Fed’s low interest rate policies. What does this mean for bond investors? It means that the market has begun to adjust to the probability of higher interest rates by building in a cushion for new investors. When the difference between short bonds and long bonds gets bigger, some of the risk is taken out of long bonds. The relationship between interest rates on bonds of differing maturities is referred to as the Yield Curve and in this instance the Yield Curve has gotten steeper. When the Yield Curve gets steeper, savvy bond investors look to see if a ride down the yield curve might be rewarding or might help reduce portfolio risk.

 

Let’s take a look at the 10 Year Treasury currently priced to yield 2.62%. If we hold this bond for a year and there are no changes in interest rates, we will now be holding a 9 Year bond. Our Yield Curve says that 9 Year bonds yield 2.33%, which is less than 2.62%. Well we have already learned that when interest rates go down, bond prices go up, right? So by just watching our 10 year become a 9 year, our price will go up and our total return (change in value + interest earned) will be about 5.00%.What if the Yield Curve moves 100 basis points higher instead of remaining the same? Then we will lose value but will still earn interest, so that our total return is -2.75%.

 

The reward for riding the yield curve with no change in rates on the 7 year is 4.23% while a 100 basis point rise in rates would produce a total return of -1.24%. For the 5 Year we’re looking at 2.71% with no change and -1.05% with a 100 basis rise and for the 3 Year we can make 1.23% with no change or we can lose (-.69%).

 

Many of the bond “experts” out there are NOW telling you to get out of bonds or, more practically, to reduce duration, i.e. shorten the maturity profile of your portfolio. That advice would have you sell your 7 Year, let’s say, and buy the 3 Year, right? Let’s take a look at that. The 3 Year currently yields .65% while the 7 Year yields 2.00%. If rates go up 100 basis points (as expected?) you will have total return of -.69% on the 3 year vs. -1.24% on the 7 year. If you are 100% sure that rates will be higher by 100 basis points next year, this trade will be marginally beneficial before taking trading costs into account. If on the other hand, we continue our low interest policies for yet another year (not unthinkable) and rates don’t change, you are considerably better off (4.23% vs. 1.23%) holding on to the 7 year. Not such an easy decision anymore.

 

We still think it makes sense to move some of your “plain vanilla” fixed income into other asset classes, including alternative investments, high yield bonds, emerging markets bonds etc. But at these higher interest rate levels and with a steeper yield curve, there is a little more value in bonds today especially when you consider the roll down the yield curve in an environment that will probably see the Fed stand pat for a bit longer than had been previously anticipated.

About Jim Jeffery, CFA

Jim Jeffery, the founder and principal of Jeffery Asset Management has joined Solaris Advisors LLC as Managing Director where he will lead the non profit senior living effort. Jim is a Chartered Financial Analyst (CFA) with more than 20 years experience in the financial services industry. Have a question about your financial plan? ASK JIM

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