Bonds

Heeding Warnings on Bonds - 2nd Quarter 2012

As an Investment Committee and firm, we have had concerns about the threat of rising interest rates for some time. The growing chorus of concern for future bond returns rose during the quarter including notable discussion from Warren Buffett in his annual Berkshire shareholder letter. 

Over the past 30 years, bonds have been a significant contributor to investor returns. It takes a veteran investor with a long memory to recall the last time that there were sustained negative real returns for bonds. Coming out of the 1970s, inflation was the chief enemy of the Fed and interest rates remained higher than inflation rates. This meant that even those investing in cash alternatives could preserve the purchasing power of their investments.

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We all know what’s happened to the rate of return for cash alternatives since 2008. It has been brutal to pay your bank more in fees to hold your money than receiving back as savings interest rates which have been negligible or nonexistent. Since inflation has hovered between two and three percent, your cash alternative has had a negative real rate of return, that is the return of the investment minus inflation.

Our concern today is that this negative real rate will spread from cash alternatives to other bond categories, most notably US government bonds. There are several ways that bond results can hurt investors:

  • Rates rise: As interest rates rise, the price of bonds may go lower. This might result in reduced portfolio values on statements.
  • Rates stay flat, inflation rises: Interest rates don’t have to rise to experience disappointing bond returns. A hidden threat is that interest rates remain extremely low while inflation rises. If you subtract the high inflation from low returns in bonds, you may end up with a negative real rate of return as mentioned below.
  • Economic deterioration: Investors who move away from bonds that are more sensitive to interest rates in favor of credit risk sensitive bonds may be disappointed if slowing economic factors result in lower bond prices for bond diversifiers.

With baby boomers retiring, the bond conundrum really hits home. A historically tried and true source of retirement income may now be a source of risk. As one investor noted, this means portfolios may need to be much more carefully constructed and complex than they were in the past.

Some specific recommendations:

  • Asset allocation: Carefully review allocation decisions with your financial planner and make sure that you are invested for the next 30 years and not the last 30 years. This is especially important if you’ve significantly altered your overall allocation in the wake of the market meltdown of 2008.
  • Diversification: Not all bonds behave the same. Many types of bonds that did not exist in the last great rising rate environment of the 1970s may offer some aid to investors, or be the best option in a lousy lot. Bonds outside of the US should also be considered. Lower volatility alternative asset classes might also be included in the potentially “better than bond category”, although they take careful consideration and analysis. With diversification comes risk and complication, professional advice is recommended.
  • Rethink income strategy: Bond coupons are not the only source of income for an investor portfolio. Stocks which pay dividends are one alternate source. Beyond that, we generally prefer a total return view where both appreciation and income can be used for portfolio withdrawals depending on which assets are overweight. This reinforces the buy low and sell high concept.

We have been discussing the threat of rising rates so much, that I feel like a broken record. Someday I will talk about a time when you could get a mortgage at 3.5%. It might sound as crazy to a younger audience as double-digit Certificates of Deposit rates sound today – something that is very difficult, if not impossible, to wrap my head around. Preparing for the shifting reality of bond returns is the highest priority of our investment committee today!

Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Melissa Joy and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice. Investments mentioned may not be suitable for all investors. Past performance may not be indicative of future results. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise. Diversification and asset allocation do not ensure a profit or protect against a loss. Please note that international investing involves special risks, including currency fluctuations, different financial accounting standards, and possible political and economic volatility. Dividends are not guaranteed and must be authorized by the company’s board of directors. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Bonds - 1st Quarter 2012

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Source: Morningstar, Inc.

It seems like bonds are defying gravity at this point.  Entering last year at near record lows for yields, fixed income, as measured by the widely recognized BarCap Aggregate Bond Index, returned 7.8% vs. virtually flat returns for large-cap stocks as measured by the S&P 500. As bond returns continued to levitate, yields deflated to new record levels.  US debt was downgraded mid-year, but markets asserted a strong vote of confidence with double-digit returns for long treasury bonds.

Where to next? Past returns are not a predictor of future performance – that’s what we’re told to say by our compliance officers and in my mind, this disclaimer could not be more apropos. With interest rates telegraphed to remain low, the Fed may delay dreaded rising rates, but the ability to replicate the returns of 2011 will be a major surprise. Diversification away from a traditional mix of government bonds may help, depending on your situation.