Are Bond Investments Dangerous Right Now?

Are Bond Investments Dangerous Right Now?
By Anthony Caruso, CPA, PFS

September 18, 2012

The short answer is “probably”. But then again, stock investments are dangerous right now too. In fact at any given time, there is some level of risk associated with any investment. It’s the nature of investing. The trick of course, is to balance that risk with reward and still sleep at night. That is my job as an investment advisor. It is also my job to help my clients determine what their level of risk really is. Risk is a funny thing. When the stock market is rip roaring, most everyone is willing to take a little more risk than they really should, and when the market is depressed, most are so fearful that little to no level of risk can be tolerated. Neither of these extremes makes for good investing and my job is to guide clients past the emotional responses to make better decisions.

There has been a lot of talk about the bond market, how risky it is, and how it is ready to implode. That conversation has been going on for several years now. The culprits for the bond bubble are the Federal Reverse holding rates unrealistically low (QE 1, QE2, the twist and now QE3), money printing, dollar devaluation, inflation, etc. These are all good points, all true, and all inevitable. The real question is, when bonds will be crushed, not if.

To recap, there was a massive shift from stocks to bonds because of the financial meltdown and bear market of 2008- 2009. Scores of investors moved from “risky” stocks to “safe” bonds. Now when I say “bonds” here, I am talking about everything from individual bonds, to bond funds and bond ETFs.

US interest rates are at historical lows. The 10-year Treasury note currently trades at about 1.8%, which is up since the announcement of QE3. The 30-Year Treasury bond now yields around 3%, which is the lowest rate in over 50 years. Can interest rates still go lower? Remember, bond yields have to go lower for bond prices to go up from here. Realistically, how much more room can there possibly be? Then again, Japan has been in this kind of funk for twenty years so anything is possible. Now if and when interest rates go up however, then the principal value of bonds will go down, and bond investors who do not take evasive measures, will lose a great deal of money.

There are many reasons why interest rates may move higher. The national debt is now 16 trillion dollars and will soon exceed our annual GDP. Think about that for a moment. The US government owes more than the total value of all goods and services produced in the USA in a year! It is only a matter of time before China (our largest creditor) and other foreign creditors start demanding higher rates to purchase our debt? When there is more risk, those who lend us money want more interest to compensate for a greater chance of not being repaid. Even the US government can go bankrupt. That is the reality. Can you say Greece (or Spain, or Italy, or Portugal for that matter)? We are not immune to insolvency just because we are the USA. The laws of economics and math are blind to borders.

Now on the flip side, the economy is still a disaster. Unemployment remains high, corporate earnings are starting to stall, the manufacturing and purchasing indexes are heading down and housing remains depressed. Europe remains a mess despite recent ECB actions to copy our Federal Reserve playbook on bond purchases, and China is slowing down. The mere fact that the Fed has rolled out QE3, in a panic mode of unlimited duration, confirms just how serious things really are. That said, there is a case to be made for interest rates and bond prices not to move significantly any time soon.

Of course, since the Fed is now moving to print money to buy mortgage backed securities, and will slow or end the buying treasuries come January, interest rates could spike for that reason alone, let alone for the reasons stated above. That could put us back to the Jimmy Carter era of “stagflation” with higher interest rates and inflation, and a recessionary economy at the same time. Time will tell.

It is obvious that the low interest rate Fed policy has promoted investors who rely on investment income (such as the elderly and retirees) to move to more risky stock investments to generate dividends and appreciation in order to make ends meet. This is why the stock market looks so good at the moment, and gives the impression that the economy is in great shape. It is not, and the stock market poses just as much risk of loss as do bonds, in my opinion, and maybe more.

So, stocks and bonds have had a nice run, but there also seems to be some scary concerns. It’s quite the conundrum. Is it time to just go to cash?

In the world of investing, gut feelings and opinions mean nothing and investing on emotions is financial suicide. If nothing else, always remember that sage Wall Street saying “the trend is your friend – until it ends.” John Bogle, the founder of the Vanguard Group, once said “The genius of investing is recognizing the direction of a trend – not catching the highs and lows.” Too many people try to time and pick the top and bottom of a position which is impossible. Riding along with the general trend is much more important the picking the exact high or low. Peter Lynch, the great Fidelity Magellan Fund manager noted that “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections, than has been lost in the corrections themselves.” I don’t doubt that.

So what is the answer? I can only tell you what I do with my money, and what I do for my clients. First of all, every client portfolio has customized proportions of equities and fixed income (stocks and bonds) based on their unique needs, age, goals, and tolerance for risk. But the proportions do not matter here, for purposes of the point I am about to make. When good advisors talk about the equities portion of a portfolio they usually speak in terms of Modern Portfolio Theory. That is, asset allocation and diversification (having different asset classes such as large companies, small companies, domestic and international companies, and alternative investments that may be appropriate at the time). There is often much less effort put in to the fixed income portion of the portfolio however. The easy way out might be to have a couple of different short to intermediate term funds, with perhaps some corporate bonds, some treasuries, or some TIPS, then call it a day.

By my way of thinking however, the fixed income investments must be equally diversified and spread among many different classes to balance risk (loss of principal) and reward (income earned). There are many types of fixed income options and doing the work to mix the right ingredients in the right proportions, will make the kind of cake grandma would serve, rather than the three day old mass produced variety from the supermarket. My approach has been to spread the fixed income money over a dozen or more funds, each with a different, yet specific purpose. Some contain government and agency bonds, some corporate bonds, some municipal bonds, some high yield bonds, some global bonds denominated in dollars, and some denominated in the local currencies. Further, there are mixed maturities and durations. On any given day, some go up in value with the stock market, and some go up when stocks are down and money flows in a “flight to quality.” Bonds with different or inverse correlations we in the biz might say. The result is to keep the overall principal invested in bonds stable (isn’t that what bonds are supposed to be for anyway), and yet collect much higher rates of interest than CDs or treasuries are currently paying (nearly nothing). While I don’t expect bonds to appreciate much from here, I am more concerned with minimizing any principal loss (to balance out the volatility of stocks), and earning income. That’s the way we do it anyway. I think it is worth the extra work.

Well that all sounds well and good you might say, but what do you do when the inevitable bond bubble finally does burst? Remember our motto – the trend is your friend. When the trend of this investment or that one starts to decline, then get out. We have predetermined rules on when to enter and when to exit, and we follow those rules. This does not mean we pick the tops and bottoms. We don’t and no one can. But we can catch the general trend and limit our downside risk. This applies to both stocks and bonds, on an investment by investment basis.

So rather than get off the bond bus too early, stay for the ride. Just be sure you pay attention and have a pre-determined plan as to where your stop is, or find an advisor that can guide you. You might just sleep a little better, after all.

Anthony Caruso, CPA has practiced as a certified public accountant and investment advisor for over 30 years. Caruso and Company, P.A. is a Registered Investment Advisor offering fee based money management, tax and financial planning. Information contained above is not intended to be a recommendation to buy or sell any specific investments, or take specific tax actions and individuals should consult with their advisors for appropriate advice relating to their individual circumstances. Find us at www.carusoandcompany.com