Bond Basics: Tips for Today's Market

08/01/2013 9:00 am EST

Focus: STRATEGIES

James Stack

President, Stack Financial Management

Jim Stack, market historian and editor of InvesTech Market Analyst, offers common-sense tips for bond buyers in the current economic and interest rate environment.

Over the past couple months, there's been a dramatic shift in the bond market that has many investors worried about their fixed income safety nets.

The recent distress in the bond market is due to a sudden rise in long-term interest rates, driven by fear that the Federal Reserve will start backing off its quantitative easing.

These programs were started by the Fed in 2009 to buy long-term bonds. These purchases have helped support higher bond prices, and have kept long-term yields and mortgage rates low.

However, the Federal Reserve is now confirming its intent to start tapering its bond buying activities by year-end, depending on the economy. Meanwhile, the yield on the ten-year bond climbed from 1.6% to as high as 2.7% in just a couple months.

While the sharpness of the bond sell-off may partly be a knee-jerk reaction to the anticipated Fed move, it illustrates the potential losses that can occur in fixed income investments...particularly in bond funds.

As seasoned investors know, bond prices fluctuate with interest rates. If rates go up, the value of bonds declines. This isn't a problem with individual bonds if you hold them to maturity. As long as the company doesn't default, you'll always get your money back, plus the coupon interest.

With bond funds, however, there is no maturity date or par value. The fund's price, or (NAV), depends on the current value of the bonds in the underlying portfolio, and in a negative bond environment, that could be much lower than your initial investment.

The critical question for bond holders is, “Where are interest rates headed in the future?” Bond funds tend to thrive when inflation pressures and interest rates are low or declining, which has been the case over the past 30 years.

Interest rates today are at the lowest level in decades, with the yield on the ten-year bond well below the 50-year average of 6.6%.

Given this historical context, coupled with an end to QE stimulus, we believe inflation and interest rates will head higher. The recent 1% uptick in rates is barely perceptible on a long-term graph, but it may be just the tip of the iceberg going forward.

Over the next decade, the primary risk for bond fund investors is from rising inflation, leading to higher interest rates and declining bond prices.

To find a previous period that might be comparable, we have to go back 40 years, to a time when the tame inflation of the 1960s gave way to rising inflation during the 1970s. Only a handful of bond funds have survived from that era. The rest have been merged out of existence due to poor performance.

Clearly, investing in bonds requires careful planning and monitoring, as the current monetary environment continues to evolve.

Despite the fact that bond funds are not as invincible as they seem, and the road ahead is uncertain, many investors want to hold part of their assets in fixed income investments for diversification. Thus, we'll offer some tips for today's bond investors...

Buy individual bonds, not bond funds.

Unless an individual bond defaults, you'll get your initial investment back, as well as the interest payments. With bond funds, there is no maturity date or par value—they continually have to accept new investments and meet redemptions, regardless of current market conditions. Bond fund prices constantly fluctuate depending on cash flows, current inflation, and interest rates.

Always buy quality...stay with investment grade bonds or Treasuries.

Bond issuers are rated by Standard & Poor's on a scale ranging from AAA for the most credit worthy firms, to C on the speculative or low end. Moody's and Fitch offer similar ratings. Bonds that are rated BBB or better are investment grade. Bonds rated BB or lower have significantly higher risk of default and should be avoided.

Ladder maturities, but keep them on the short end of the scale.

Select individual bonds so that part of the portfolio matures each year. For now, we recommend staying with shorter maturities of less than five years. As interest rates rise, you'll be able to take advantage of higher yields when bonds are replaced.

If you can only invest in mutual funds, stay with high-credit, quality, short duration bond funds, or even cash, or a money market fund, for money you can't afford to lose.

When evaluating bond funds, duration is a more useful gauge than average maturity, as it also takes into account the present value of future coupon and principal payments, and provides a good indication of the fund's sensitivity to interest rates.

The greater the fund's duration, the more sensitive the fund's share price will be to changes in interest rates. Although it's not a precise measurement, a bond fund with a duration of five years would be expected to lose 5% in value for every 1%-point increase in long-term interest rates.

A duration of ten years would imply a 10% reduction in NAV for every 1%-point increase in rates. Bond fund durations can be found at Morningstar.com or on the fund's Web site.

Never stretch for yield.

The only way to get higher yield in today's market is through longer maturity or lower credit quality. Remember, there's no free lunch...higher yield invariably means higher risk.

As Mark Twain once said, “I am more concerned with the return of my money than the return on my money.” And most bond investors today probably share that sentiment if their primary concern is protection and preservation of fixed income assets.

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