A new client of ours recently received unexpected money. Wanting to act wisely and give his cash a chance to grow, he told us that he wanted to invest in “something safe.” We asked him if he had any ideas and he immediately replied: Bonds. Twenty years ago, we would have agreed that bonds were a safe investment. But with interest rates rising as they are today, yesterday’s “sure thing” is quickly becoming today’s risk.
Let’s refer to our new client as Bob. Bob is a typical retiree. He lives with his wife, who is also retired, and they have two grown children with families of their own. Bob and his wife receive monthly social security and pension payments from their previous employers. In addition, they receive IRA distributions from their retirement savings.
Investing in bonds (or bond mutual funds or bond trusts) to supplement pensions and/or Social Security income has been a typical “safe” move for many retirees for the past 20 years or more. With interest rates falling, seniors who committed to high fixed interest rate investments received substantial interest payments and, in many cases, saw their principal grow as well.
However, nothing lasts forever, and because interest rates are cyclical in nature, bonds are not necessarily the safe investments that many people consider them to be. Let’s explain: when interest rates go down, bond prices go up. Now, with interest rates at 45-year record lows, we think the chances are high that rates will start to rise. The Federal Reserve, also known as “The Federal Reserve” (under the leadership of Alan Greenspan) has a large impact on interest rates. Banks will increase their prime rate in line with increases in the federal funds rate. Eventually, after enough short-term rate hikes, we predict long-term rates to follow. Soon after, the bond market will have to catch up and bond prices will be forced in one direction: down.
Here’s what our friend Bob looks like: short-term interest rates are rising, while long-term rates haven’t caught up yet. Long bond yields are falling, which means long bond prices are rising due to the inverse relationship between yield and price. Something is definitely wrong with this image. With interest rates going up, how can long-term bond prices go up too? Remember what we said about the other important inverse relationship, the one between bonds and interest rates: It’s only a matter of time before longer bond markets correct and long bond prices start to decline.
If you’re confused by all of these relationships, don’t worry…many financial professionals feel the same way. However, you are probably wondering: What can I do to protect my investment portfolio? Well, this is what we recommend:
1) Review your investment objectives.
2) Review the time frame of your investment.
3) Ask your broker/advisor what options you have regarding prevention of loss of principal and income.
The good news for Bob and others like him is that there are strategies available to help you protect your money. One strategy we recommend is to shorten and stagger the maturities of individual bonds so that the money matures periodically. This will allow Bob to assess the interest rate environment on a regular basis, giving him the option to purchase additional bonds at the current interest rate or wait for rates to change.
Due to widespread confusion and misunderstandings when it comes to bond investments, it’s important to remember the difference between various bonds and bond funds. US government Treasury bonds (T-bonds), municipal bonds, corporate bonds, “junk” bonds, bond trusts, government bond mutual funds, municipal bond mutual funds, etc. are some of the most common ways an investor can participate in the bond market. But as with any investment, each of these bond investments has its own ratings, risks, return predictions, and principal warranties. For example, with US government bond mutual funds, there are NO principal guarantees.
We’re not suggesting that Bob should avoid the bond market like the plague, just that he should keep an eye on it. He can still make money by investing in bonds, but with interest rates rising, there is clearly more potential for loss. Our goal is to help Bob maintain a lifestyle that involves choice. We want him to enjoy the upcoming vacation with his wife, the new car every four years, summer camp for the grandkids… Bob has worked hard all his life to make these things happen. By closely watching his portfolio and carefully investing in the bond market, we’re confident that Bob will be able to turn his plans into reality, despite rising interest rates.