Don’t let rate fears scare you out of bonds
Reprinted courtesy of MarketWatch.com.
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Last month I spoke to a group of about 180 investors in the Seattle area and it quickly became obvious that one of their biggest concerns was about bonds and future interest rates.
In my talk, I asked for a show of hands on who was afraid to invest in bonds. Most people raised their hands. Then I asked for another show of hands on who was afraid to invest in stocks. Only two hands went up.
“How can you suggest I put money into bonds when you know they are going to go down?” asked one woman.
It’s a good question. By that standard, I should certainly never suggest that anyone invest in equities. Indeed, I often tell people that if they invest in equity funds, they are virtually guaranteed to lose money at some point.
“I think bonds are riskier than stocks,” said a man in the audience.
I was startling to realize that only about one in 100 of these relatively knowledgeable investors were concerned about the very real risk that their equities could decline by 50%. Yet most of them were worried that their bondholdings might decline by 5%.
Yes, interest rates are a real concern. Millions of Americans can see as plain as day that any significant change in rates will have to be upward. As most people know, that’s bad news for prices of existing bonds, since bond prices and interest rates almost always move in opposite directions.
But is the prospect of higher rates necessarily bad news for the investors who own those bonds? I don’t think so.
Had I been speaking to a group of people whose main investment objective was to make a profit from buying low and selling high, their concern would make perfect sense. Because rates are so low, bond prices are relatively high, making this a good time to sell them at a profit.
However, as far as I know, most of the people in this room own bonds (or think they should own bonds) to stabilize their overall portfolios and reduce the risk of owning stocks.
Fearing stocks makes a lot more sense than fearing bonds. If you want bonds to mitigate your potential losses from stocks, the only way to get that protection is to hold on to those bonds.
I agree with the general consensus that interest rates are bound to rise at some point. This has been a valid expectation for most of the past 20 years. But nobody knows when rates will go up, how far they will go up or how fast they will go up.
So why the widespread fear of bonds? I think one major reason is that there are only two variables to track: interest rates and prices. On the other hand, there are more than 200 legitimate reasons why stock prices may rise and fall. That matrix is far too complex for the human mind.
The easiest of these factors to understand is recent performance; the stock market has been up since March 2009, breeding what I believe is false confidence and dulling the memory of the very real pain of past bear markets.
Another reason for the current widespread fear of bonds was expressed well by my friend Dennis Tilley, chief investment officer for Merriman. (I founded this investment firm in 1983 but am no longer affiliated with it except as a client.)
For more than 15 years I have relied on Dennis’ research and conclusions for much of my own portfolio, and I think he’s right on the money.
“Unfortunately, the financial news media has blown this story way out of proportion with inflammatory headlines designed to capture attention,” Dennis wrote in an article earlier this year.
Headline language like “the coming bloodbath for bondholders” and “the imminent bursting of the 30-year bond bubble” have predictably riled up many investors.
At best, such headlines are misleading, prompting investors to focus on the wrong things. At worst, they are cynical devices designed to sell newsletters and scare people into thinking they need some special information to survive “the coming collapse.”
Even though bonds (at least on the surface) are relatively simple, many investors seem not to understand that rising interest rates will be beneficial for shareholders in money-market funds and short-term to intermediate-term bond funds. As a fund’s holdings mature, the money will be reinvested at higher rates, producing more income.
Many years ago Dennis Tilley and I, along with the rest of our company’s research team, decided to determine which fixed-income investments offer the best profile of risk and return for stabilizing an equity portfolio during bear markets.
We concluded that the best option in tax-deferred or tax-free accounts is a combination of TIPS funds and short-term to intermediate-term U.S. government securities. (In taxable accounts, tax-exempt bonds or bond funds are sometimes preferable.)
As Dennis pointed out in his article, U.S. government bonds (and muni bonds) provide long-term after-tax returns higher than inflation. Their prices are relatively uncorrelated with other asset classes, meaning they will likely rise in value when equities and high-yield bonds are falling.
In my own investments, the effective duration of my bondholdings is approximately four to five years. This means that if interest rates rise by one percentage point, their value can be expected to decline by approximately 5%.
Some investors will ask: Why own bonds at all if they are going down and stock prices are going up? The answer is pretty simple: If I actually knew that bond prices were going down and stock prices were going up, of course I would adjust my investments accordingly. But neither I nor anybody else can have such advance knowledge.
Dennis cites three common-sense reasons that investors should ditch their worries about rising interest rates.
First, experts and consensus opinions are often wrong. The history of investment markets is full of examples of times when “everybody knew” something was bound to happen, and it didn’t. Yet when most investors are certain that some event is inevitable, that event is already built into the pricing of securities that would be affected.
For example, if “everybody” is convinced that bonds are a lousy short-term investment, the big money and “smart” money has already sold them.
Second, a portfolio duration of four to five years is the sweet spot for bondholdings. Based on many past market scenarios, this seems like the best combination to provide a long-term return above inflation while mitigating losses in stocks. In addition, such intermediate-term holdings can quickly adapt to a rising rate environment.
I am convinced that having this combination in my portfolio means I don’t have to worry about rising rates.
Third, for investors who own both equities and bonds, the rising-rates scenario is likely to be favorable. There’s no guarantee of this, but rising interest rates are likely to coincide with an improving economy that is good for stocks. Bonds may suffer single-digit percentage losses, but in a robust economy, stocks can easily experience double-digit gains.
This is the way a properly diversified portfolio works: One asset class declines while another rises to offset the loss, either partly or fully
For these reasons, I think the current fear of bonds isn’t justified. If you really care about your long-term investment returns, I have three pieces of advice:
First, do your best to park your emotions elsewhere. Second, ignore the inflammatory media hype and refuse to join the herd mentality. Third, find a good long-term balance in your portfolio between equity funds and fixed-income funds — then stick to it.
Richard Buck contributed to this article.