Investors that are wondering when it's safe to get back in bonds have a very important factor choosing them: They recognize an actual risk that lots of don't.
However the question still heads down the wrong path. Generalizations in regards to the timing of engaging in and out of asset classes are rarely accurate, and they distract from the more productive goal of focusing on which you certainly can do to maintain your long-term financial health. The answers a number of other questions about bonds, however, will help in determining a suitable investment strategy to meet your goals.
Before we speak about their state of the bond market, it is essential to discuss what a bond is and what it does. Although there are a few technical differences, it is easiest to think of a bond as a tradable loan. Bonds are obligations of the issuer, acting as a borrower, to repay a specific sum with interest to the lender, or bondholder. Bonds are often issued with a $1,000 "par" or face value, and the bond's stated interest rate is the sum total annual interest payments divided by that initial value of the bond. If a bond pays $50 of interest annually on an original $1,000 investment, the interest rate will soon be stated as 5 percent.
Simple enough. But after the bonds are issued, the present price or "principal" value, of the bond may change because of many different factors. Among these are the general degree of interest rates available in the market, the issuer's perceived creditworthiness, the expected inflation rate, the quantity of time left until the bond's maturity, investors' general appetite for risk, and supply and demand for the specific bond.
Though bonds are normally perceived as safer investments than stocks, the reality is slightly more complex. Once bonds trade on the open market, an individual company's bonds will not always be safer than its stocks. Both stock and bond prices fluctuate; the relative danger of an investment is essentially an issue of its price. If all types of markets were completely efficient, it is true a bond would always be safer when compared to a stock. The truth is, this is simply not always the case. It's also possible that a stock of 1 company may be safer when compared to a bond issued by a different company.
The reason why a bond investment is perceived as safer than a stock investment is that bondholders are ranked more highly than shareholders in the capital structure of an organization. Bondholders are therefore more apt to be repaid in the case of a bankruptcy or default. Since investors want to be compensated with added return to take on additional risk, stocks should be priced to offer higher returns than bonds in respect with this higher risk. As a result, the long-term expected returns in the stock market are often higher than the expected return of bonds. Historical data have borne out this theory, and few dispute it. Given this information, an investor looking to increase his / her returns might think that bonds are just for the faint of heart. invest in bonds
Why Invest In Bonds?
Even an aggressive investor should pay some awareness of bonds. One good thing about bonds is that they have a low or negative correlation with stocks. Which means when stocks have a negative year, bonds in general prosper; they "zag" when stocks "zig." In most calendar year since 1977 by which large U.S. stocks experienced negative returns, the bond market has had positive returns of at the least 3 percent.
Bonds also provide an increased likelihood of preserving the dollar value of an investment over short amounts of time, because the annual return on stocks is highly volatile. However, over longer periods of 10 years or maybe more, well-diversified stocks virtually guarantee investors an optimistic return. If an investor should withdraw money from his / her portfolio over the following five years, conservative bonds are a sensible option.
Even if you are not going to withdraw from your portfolio, conservative bonds provide an option on the future. In a downturn, you are able to redeploy the preserved capital into assets which have effectively gone for sale during industry decline. Bonds in a portfolio reduce volatility, cover short-term cash needs and preserve "dry powder" to deploy opportunistically in a market downturn. They're all sensible uses. On another hand, overinvesting in bonds can pose more risks than investors may realize.
What Are The Risks Of Bonds?
Imagine bonds' current values and interest rates sitting on opposite sides of a seesaw. When interest rates increase, bond prices go down. The magnitude of the reduction in bond values increases since the bond's duration increases. For each and every 1 percent change in interest rates, a bond's value can be expected to improve in the alternative direction by a portion corresponding to the bond's duration. As an example, if industry interest rate on a bond with a two-year duration increases to 1.3 percent from 0.3 percent, the bonds should reduction in value by 2 percent. If rates normalize to the historical average of 4.2 percent, the two-year bond should reduction in value by about 7.8 percent.
While such negative returns are not appealing, they're not unmanageable, either. However, longer-term bonds pose the true risk. If interest rates on a 10-year duration bond increased by the same 4 percent, the present value of the bond would decrease by 40 percent. Interest rates are still not definately not historic lows, but sooner or later they're bound to normalize. This makes long-term bonds specifically very risky as of this time. Bonds tend to be known as fixed-income investments, but it is essential to acknowledge that they provide a fixed cash flow, not really a fixed return. Some bonds may now provide nearly return-free risk.
Another major danger of overinvesting in bonds is that, although they work very well to satisfy short-term cash needs, they could destroy wealth in the long term. You can guarantee yourself near a 3 percent annual return by investing in a 10-year Treasury note today. The downside is that if inflation is 4 percent over the same time frame period, you're guaranteed to get rid of about 10 percent of one's purchasing power over that point, even although dollar balance on your account will grow. If inflation reaches 6 percent, your purchasing power will decrease by more than 25 percent. Conservative bonds have historically struggled to keep up with inflation, and today's low interest rates show that most bond investments will more than likely lose the race. Having a traditionally "conservative" asset allocation of 100 percent bonds would actually be riskier when compared to a more balanced portfolio.
The Federal Reserve's decision to maintain low interest rates for a long period was meant to spur investment and the broader economy, but it comes at the trouble of conservative investors. In the face of low interest rates, many risk-averse investors have moved to riskier regions of the bond market looking for higher incomes, as opposed to changing their overall investment approaches in an even more disciplined, balanced way.
Risk in fixed income comes in several primary varieties: credit risk, interest rate risk, currency risk and liquidity risk. Some investors have shifted their investments to bonds from lower-quality issuers to earn more income. This strategy can backfire if the company's ability to meet its obligations decreases. Longer-term bonds also pay higher incomes than their shorter-term counterparts, but will lose substantial value if interest rates or inflation rise. Foreign bonds may have higher interest rates than domestic bonds, however the return will ultimately depend on both the interest rates and the changes in currency exchange rates, which are hard to predict. Bondholders may also manage to generate more income by finding an obscure bond issuer. However, if the bond owner needs to offer the bond before its maturity, he or she might need to do this at a sizable discount if the bonds are thinly traded.
The growing listing of municipalities which have defaulted on bonds serves as a note that issuer-specific risk should be a real concern for all bond investors. Even companies with good credit ratings experience unexpected events that impair their capability to repay.
Accepting more risk in a bond portfolio isn't inherently an unhealthy strategy. The issue with it today is that the buying price of riskier fixed-income investments has been driven up by so many investors pursuing the same strategy. Given how many investors are hungry for increased income, dealing with additional risk in bonds is likely not worth the increased return.
Given The Risks, What Do We Suggest?
We recommend that investors give attention to maximizing the sum total return of these portfolios over the long term, as opposed to trying to increase current income in today's low interest rate environment. We've been wary of the risk of a bond market collapse because of rising interest rates for a long time, and have positioned our clients' portfolios accordingly. But that will not mean avoiding fixed-income investments altogether.
While it might be counterintuitive to believe adding equities can in fact decrease risk, based on historical returns, adding some equity exposure to a bond portfolio supplies the proverbial free lunch - higher return with less risk. For individuals and families that are investing for the long term, the most significant risk is that changed circumstances or an extreme market decline might prompt them to liquidate their holdings at an inopportune time. This may ensure it is unlikely that they might achieve the expected long-term returns of a given asset allocation. Therefore, it is essential that investors develop an approach that balances risks, but they must also understand and accept the inherent volatility that accompanies a growth-oriented portfolio.
Conservative investments are meant to preserve capital. Therefore, we continue steadily to recommend that clients invest many their fixed-income allocations in low-yield, safe investments that should not be too adversely suffering from rising interest rates. Such securities may include money market funds, short-term corporate and municipal bonds, floating-rate loan funds and funds pursuing absolute return strategies. Although these investments will earn less in the temporary when compared to a riskier bond portfolio, rising rates will not hurt their principal value as much. Therefore, more capital will soon be available to reinvest at higher interest rates.
Investors should also achieve some tax savings by emphasizing total return as opposed to on generating income, as long-term capital gains realized from the sale of appreciated positions will receive more favorable tax treatment than will interest income that's susceptible to ordinary income tax rates. Moreover, emphasizing total return will also mitigate exposure to the brand new tax on net investment income.
So When Is It Safe To Get Back Into Bonds?
Despite my initial claim that this is simply not the best question to ask, I will provide you with an answer. Once bond yields commence to approach their historical averages, we will recommend that investors move certain assets into longer duration fixed-income securities. But you cannot wait for the Federal Reserve to improve interest rates. Like every other market, values in the bond market change based on people's expectations of the future. Even in normal interest rate environments, however, we typically advise clients that many their fixed-income allocation be committed to short- and intermediate-term bonds. Bonds are for protecting your wealth, not for risking it.
