Bonds & What To Do When They Go Boom!

  For the last year or so we’ve heard the horrors of what is going to happen when interest rates start to increase. Bond principal falls as rates increase. It does just the opposite when rates fall. Before you panic, because rates are due to increase remember our economy is still fragile and you should not expect higher rates anytime soon. Experts think the third or fourth quarter of 2011 may be when we see rates moving up.

There are both dangers and opportunities when the Fed starts moving interest rates. You do have to do certain things when rates move higher otherwise you will, if you own domestic bonds, lose money. How much money you lose is dependent on the type of bond you own, the maturity and how high rates go up. A Morningstar interview with a bond portfolio manager suggested that once the process of higher interest rates starts the it may continue for years before rates hit their peak.

How much can you lose? A recent WSJ article illustrated that a one-point jump in Treasury yields would translate to a 5% loss for a 10-year Treasury note and a 12% drop for a 30-year Treasury bond.

These so-called experts blame you, me and the candle stick maker for buying bonds and avoiding stocks over the last few years. They blame us for chasing yields, ignoring stock dividends and trying to make as much money in the safety of bonds as we can. They also look down at us from their Ivory Towers as not having enough sense to get out of the way when bonds turn and interest rates go up. We are told that the American investor has loaded up to excess on fixed income when the truth is that both foreign investors and the U.S. government own the vast majority of bonds.

The Federal Reserve owns $1.2 trillion of mortgage securities and foreign investors have bought $373 billion of Treasuries or 60% more than the average Joe and Josephine has put into ‘all’ bond funds combined.

It does not matter if you own corporate or government bonds they both react to rates the same way. If you are owners of short-term, intermediate, municipal, high-yield or foreign bonds the volatility is somewhat different. Some bond issues will be affected and others, such as foreign, may not.

If you ignore increasing interest rates it is possible to lose a significant amount of money. Assume you bought a $10,000 bond with a 4% coupon. The bond matures in 10-years. You can sell it at any time between now and then for whatever value the market is willing to pay for it.

If interest rates suddenly jump 50% and new bonds are offered at a 6% interest rate a 4% bond needs to have principal reduced in order to equal a 6% yield. On a ten thousand dollar bond the value would be reduced by $3,300.

When rates start to climb an investor has choices. If you own an individual bond you may decide to simply hold the bond to maturity rather then take a loss. If you own bond mutual funds you may not have that luxury. While bond managers will be scrambling to sell old holdings and buy new they will be losing principal on their original bond portfolio.

The good news is that nothing is as extreme as rates moving up 50% overnight. Rates will move up eventually but usually at a fraction of a percent. But having a plan in place as to what to do when rates do go up is necessary.

• Don’t panic. A lot of smart money is waiting to take advantage of rising interest rates. You can too.
• Check maturity of individual bonds. 1-2 years out you may want to hold and get income and wait for them to mature.  You won’t lose anything by doing that except what new bonds are paying.
• Domestic bond mutual funds and closed-end funds need to be sold. Have your broker place sold assets in a money market. Sales can be made tout de suite with minimal loss of principal. You will lose money as rates move up so you do have to act swiftly.
• Research ETFs that short the 10-year or 20-year Treasury. The ETF will act positively as rates move up.
• Research TIPS.  These are Treasury Inflation-Protection Securities. Higher rates usually mean inflation and TIPS can add a protective layer to a conservative portfolio.
• Start today to buy dividend paying stocks and mutual funds. Today you can get 3%-6% on a slew of different investments. Waiting  until a later date and you may find the prices bid up and the yield not so attractive.
• Cash is also good- temporarily. Some folks think they’ll see the 18% fixed money market days of Carter but remember we worked our way to those returns and they didn’t happen overnight. Then there is always the probability we may not see those days. An investor can always sell a 6% dividend asset to buy a double digit asset when the time and opportunity arrives.
• Finally, don’t forget that going forward new issue bonds will be pegged to competitive rates. Investors may be able to buy brand new bonds at the new rates which could be in double digits as they were back in 1980.  After bond yields peek they usually fall providing investors with increased returns.

Questions for Paul call 877 783 7080 or write him at pstanley@westminsterfinancial.com. Share this blog with someone who cares about their money.