“The Future of Bonds”
July 8th, 2013
In the second quarter of this year, the yield on the 10-year Treasury bond rose 54 basis points to 2.24 percent in the span of one month. Economists have been predicting the eventual rise in interest rates, but a jump this big over such a short time frame was not expected.
If you own a substantial bond allocation in your portfolio, it’s a good time to reassess what you own – and why. Earlier this year, private industry regulator FINRA (the Financial Industry Regulatory Authority) issued a warning to investors regarding the adverse relationship between bonds and rising interest rates. Since bond prices typically drop when interest rates rise, an outstanding bond – particularly one with a low interest rate and high duration – might experience a significant price drop. This means that bond funds invested primarily in long-term bonds will decline in value.
Currently, there are about $1.2 trillion of fixed income assets invested in defined contribution plans such as 401(k)s, according to a study by Casey Quirk published in May. If interest rates increase to even half of their historical average, these plans will likely lose up to $180 billion in value. However, just because interest rates might rise and bond prices subsequently fall, you may not need to be concerned. It depends on the reason why you own bonds in the first place. Are they part of an overall asset allocation? Do you use them for regular income, or to help diversify a stock-laden portfolio? Your bond allocation depends on many factors, such as your objectives for income and future goals, your investment timeline and how well you tolerate risk in the markets.
Perhaps you own individual bonds to secure a predictable income stream and a known schedule for the return of your principal. If this is your objective, then you needn’t be too concerned with rising interest rates. You will continue to receive income regardless of the direction of interest rates, and your original principal will be returned upon maturity.
However, if your bond holdings are designed to help minimize the overall volatility of your portfolio, rising interest rates might present a risk you hadn’t considered. If the value of your bonds slips at the same time that your equity holdings experience volatility, your portfolio’s market value could drop substantially.
The market value of bonds tends to be inversely affected by movements in interest rates because:
• When rates rise, market prices of existing debt securities fall as these securities become less attractive to investors when compared to new issues with higher coupon rates.
• When interest rates fall, market prices on existing fixed income securities tend to rise because these bonds become more attractive when compared to newly issued bonds priced at lower rates.
Note, too, that government and other investment grade bonds tend to be more sensitive to changes in interest rates.