INVEST IN BONDS NOW-at Your Own Peril

By in Asset Allocation, Bond, Investing, Money Management | 11 comments

MAIN TOPIC: Learn Bond Characteristics and Prosper

When I began investing many years ago, I was quite afraid of investing in stocks because I thought they were too risky.  I believed bonds could get me a bit more return than cash with less risk than stock investments. In general, that belief is sound; but not now.

In “Stop Gobbling Up Bonds,” by Paul J. Lim, January/February Money Magazine, a couple of reasons why investors are seeking bonds now were cited:

  • Fearful investors seek safety in Treasury bonds.
  • Risk seeking investors are chasing higher bond yields.

 Unless these investors hold the bonds until maturity and don’t care about watching their values decline, they will lose money when interest rates rise!

My earliest teacher of investment principles was my dad. He drilled this FUNDAMENTAL BOND PREMISE into me. It served me well in the beginning and still governs my investing today.

The price of a bond moves in the opposite direction of interest rates.

Simply put, investors witnessed this principle during the past decade, to their collective benefit. The Federal funds discount rate (a proxy for most interest rates) went from 6% in May, 2000 to .75% in January, 2011. This drop in interest rates is the predominant REASON BOND VALUES HAVE INCREASED during the past decade. If you held bonds during the past decades, your returns have been stellar!

PRACTICAL APPLICATION: Where do Bonds Fit in Your Portfolio?

Many investors (myself included) are bemoaning the lack of conservative investments available with higher yields. As anyone schooled in investing basics understands, a balanced asset allocation with percentages in stocks, bonds, and cash is sensible.

Then what’s an investor to do with the bond portion of her portfolio NOW?

Since the bond portion is supposed to offer stability and temper volatility, now is a poor time to allocate new monies to bond investments. The value of monies invested now, wil surely decline as interest rates rise. Here are some options for the “fixed” portion of your assets:

  1. If you are holding individual bonds, and expect to keep them until maturity, do nothing. The ups and downs in value are irrelevant as you receive the full (face) value of the bond at maturity.
  2. If  you typically invest in bond funds, only allocate new money to funds with extremely short maturities, or not at all.
  3.  Consider paring down your current holdings in bond funds, to capture the capital gains and shield your money from future losses.
  4. Put new money into a Certificate of Deposit (CD) instead. PFstock had an interesting idea; he recommended finding a 5 year CD with a competitive interest rate. Make sure the “early withdrawal penalty” is not more than a few months interest. That way, you’ll get a decent yield, your principle is protected, and if you withdraw the funds early, you still come out ahead of investing in a shorter term CD with a far lower interest rate. 

In investing as in life, change is a constant. As the markets cycle and interest rates move upward, you’ll have an opportunity to devote resources to bonds offering much higher yields.

ACTION STEPS:

 Get a notebook and label it: “(your name) Personal Finance” and keep it by the computer. Use it to keep all of your personal finance goals, thoughts, activities, and plans.

  • Devote one hour to review your investments.
  • Make sure you understand the investments in your retirement account.
  • Commit to saving money on a regular basis.

If you like what you’re reading, pick up my RSS feed and follow me on twitter so you get the word immediately.  

How are you handling the fixed portion of your portfolio now?

This article is for information purposes only and not as a recommendation to buy or sell any individual securities. The information contained herein may not be applicable for your situation. Consult your ownpersonal advisor for investment information.

image credit: businesspictures

    11 Comments

  1. Very good post Barb! Instead of blindly allocating money in bonds, knowing why bond prices go up or down helps in proper asset allocation.

    Moneycone

    January 15, 2011

  2. It is wise to keep *some* exposure to bonds, the short term ones, as there are a lot of uncertainties out there!

    BeatingTheIndex

    January 15, 2011

  3. @Moneycone and Beatling the Index- Although bonds are important in the overall asset allocation, as you said Money, as in any investment, you better know what you’re investing in. Beating, I agree one should have a bond allocation and if you are one to add to that now, absolutley, make it a short term position! …. That way, when interest rates rise, you won’t be locked into long term low returns along with the reduced principal value.

    Barb

    January 15, 2011

  4. I’m not liking the excessive manipulation in the bond markets (that could also be conceivably hitting the stock markets); however, I think bonds are more of a bubble than equities right now. I’m not going to be putting too much money in them for a while… though OTOH sometimes I wonder if a 13% Greek bond wouldn’t have been such a bad idea at the time.

    Kevin@InvestItWisely

    January 16, 2011

  5. Hi Kevin, Some of those higher yields in international bonds are quite compelling. Unfortunately, with the impact of currency fluctuations, there is a high degree of risk.

    Barb

    January 16, 2011

  6. Barb, great review.

    I have been considering a few muni’s as I think the default concerns are overdone. Even in this environment, there are states and cities without all the fiscal problems that make the headlines. These, because of their tax status are only appropriate for taxable accounts…as you know!

    High grade corporates also have reasonable returns for new money-but agree short term is best right now.

    Bonds drive most people batty, but the main risk right now, IMHO are in the long-term treasuries.

    Dr Dean

    January 16, 2011

  7. I recently exchanged my bond funds for an equity index fund. So far the return is significantly better.

    krantcents

    January 16, 2011

  8. @Dr. Dean; I agree regarding the default risks being overblown. That said, I’m with you on term, stay short term!
    @Krantcents-As long as the invested funds are not needed for the next 5 to 10 years, you are okay. Although not one to predict….I think there will be plenty of time for bonds with better yields, when the interest rates rise.

    Barb

    January 18, 2011

  9. Thank you for mentioning PFStock in your post. For the record, the post where I discuss the 5-year CD strategy is this one: Pay the Early Withdrawal Penalty. I hope that your readers find it useful.

    pfstock

    January 21, 2011

  10. Good info, Barb and spot on! In my opinion, too, investing in bonds right now would not have a beneficial result. Note that even the financial institutions (the pros) are holding excess cash instead of re-investing it in securities as there are few compelling opportunities and the securities they are buying are keeping their portfolio durations short (~ 2 years). Maturities past the time-frame of the Fed holding rates artificially low into 2015 carry very high interest rate risk right now as you point out. I believe the economy is showing slow but more consistent positive signs and when the Fed changes to inflation-fighting mode, rates will jump quickly for a short time which could crush bond investors who must or want to sell prior to longer-dated maturities (i.e. bond bubble bursting).

    Dan Teclaw

    March 12, 2013

  11. Hi Dan,

    Thanks for weighing in! As the Fed is wavering regarding how long to keep interest rates low, investing in anything but the shortest of bond maturities is the closest one will get to a guaranteed future loss on principal.

    Barb

    March 12, 2013

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