|Historically, people have purchased bonds for income and have a portion of their money in rather conservative investments. However, with current bond yields and CD rates very close to zero, we have seen a shift in focus from income generation to preservation of capital. Basically, most investors attempt to safeguard their money for fear of losing their acquired wealth. One must be aware, though, that with every investment comes an element of risk, and this even pertains to U.S. Treasuries. Because fixed income is currently a hot topic, I wanted to give you an overview of the risk associated with fixed income investments and how to minimize that risk when interest rates start to rise.
Interesting Facts About Bond Pricing and Long-term vs. Shorter Term Bonds
Let’s take a quick look at long-term bonds. Since 1980, their yields have dropped from 15.2 percent to 4.4 percent (as of March 2011). If interest rates on those Treasuries Bonds increase to 5 percent (only a .6 percent increase), a 30-year Treasury could sink 9 percent. That is a significant amount of risk with what is supposed to be your “safe stash.”
Think of it like this: assuming you have a bond priced at $1,000 that gives 4 percent interest, and interest rates go to 8 percent, you would have to sell that bond at a discount so the new buyer would get the street rate of 8 percent. On a long-term bond, that discount can be as much as 50 percent (or more if the quality of the issuer is in question).
This year many experts say they believe interest rates will rise because they see clear signs that the economy is finally getting up off of the floor, so this is something you need to be looking at! The ultimate goal is for you to be aware of upward trends in the market so you can capitalize on it.
Key Tips for Bond Investing
1. How do interest rates affect bond prices? As interest rates rise, bond prices generally fall. The degree that they will fall is based on the duration (term) of the bond and the quality of the issuer. The longer the duration, the more the price of the bond will drop if rates rise. In addition, interest rates do not have to rise for prices to fall. Even the threat of interest rates going up will cause bond prices to fall.
2. Do I hold onto my existing bonds or sell them? That is situational and you really need to consult with a qualified financial advisor. If you hold a bond to maturity you get your initial investment back (or at a minimum, the face value of the bond). Your specific tax, liquidity and income situation, need to be taken into consideration.
3. If I am buying bonds now, what should I focus on? I would focus on staying in short duration bonds for two reasons: They are much less volatile then longer term bonds, and as the bonds mature, you can reinvest them at higher rates faster than if you were in longer duration bonds.
4. What about U.S. Treasuries? I can’t lose money in that! As I said earlier, every investment, including U.S. Treasuries has an associated risk. That risk can be credit risk, described as when you are not sure if the issuer can pay, or things like interest rate risk, where if rates rise your investment is worth less. Bill Gross, probably the best known bond expert from PIMCO, recently announced he decided to move entirely out of U.S. Treasures! Bill Gross oversees $1.1 trillion in investment assets and is PIMCO’s co-chief investment officer. This declaration is groundbreaking!
Understand Your Risk Now
Often people say that interest rates cannot go up that much. When I got out of college in the 1980s, interest rates for new homes were at 18 percent. Every $100,000 of money borrowed you had interest payments alone of more than $18,000 annually. Interest rates inevitably have to increase and it is simply a matter of how much and when. My advice is to take a look at your exposure before it is too late and do something about it today to have a better tomorrow!
Jerry Lynch is president of JFL Consulting and has more than 23 years in insurance and financial planning. He has been a regular guest on CNBC, WABC and does regular articles for the Star Ledger. He can be reached at firstname.lastname@example.org.
By Jerry Lynch, CFP, CLU, ChFCPosted on: April 14, 2011