Have You Fled to Bonds for Safety? Be Warned.
Jun 07 2010
Bonds funds are being purchased at a blistering pace for the last several years. The ups and downs of our stock funds have left us gun-shy about the use of stocks in helping us create the wealth we need for the future. The purchase of bonds to counteract volatile stocks in combination with our nation’s and the world’s economic policies are setting up the next bubble that will pop in the future. Bonds.
Bonds are tricky because they lure us into a false sense of security. They’re always safe, right? You can count on them to produce a steady return of interest payments. Or said another way, they provide a consistent positive return, right? This is true if you own individual bonds and hold them to maturity–assuming they are quality bonds and the bond issuer is financially solid. With a bond fund however, you own a portfolio of bonds and those bonds’ values fluctuate with the bond market. Since it’s the value of your account that tends to matter the most, when the value of those bond funds starts to drop, will you wish you had a smaller allocation percentage in bond funds.
Bond values are influenced by things like inflation and rising interest rates and the quality of the issuer. Inflation eats away at your return. If you’re getting 4% interest on your bond and the inflation rate rises to 5%, your value will drop. If interest rates rise, the value of your bonds decreases. Who wants your 4% bond if new bonds offer 5%? What happens if people question the financial stability of the bond’s issuer? Two things; the added risk due to the issuer’s financial problems decreases the bond’s value and people jump ship so the value of the bond drops.
Given the examples above, what do you believe are the chances of inflation and interest rates rising in the future? What about the financial stability of the governments or corporations who issue bonds?
What is a person to do?
If you still contribute to your funds on a regular basis–as a 401k at work. You should be fine over the long haul. Regular contributions take advantage of a strategy known as ‘dollar cost averaging’ or ‘averaging down.’ This strategy works by buying more shares of funds as the price of the funds drop. You know, buy low. Buying low lowers your average share cost which enhances your account value as the bond market values return. If you average down, market downward swings are your friend provided you have a time line that allows the market to return before you need the money in retirement.
If you are close to or in retirement. Consider the need to minimize the potential losses by diversifying your portfolio. Ask yourself, if your bond funds go down in value can you afford to the take the hit in your account value? If the answer to this question makes you nervous, you might want to talk to your advisor about alternatives to your bond funds to spread the risks. Maybe it’s just a matter of diversifying the types of bond funds you own. Not all bonds funds react the same to the factors listed above. There are other vehicles besides stocks and bonds that could help cushion the impact of a negative bond environment.
MOAA does not sell investment products and we do not provide financial planning from our staff. We act as financial counselors and educators helping people become savvy consumers.
We purchased several Treasury I bonds several years ago with what we thought was an excellent interest rate. We were told that the interest was a two-part interest — one fixed and one variable. For several months during the past year or so we received NO interest whatsoever on our I Bonds. The government was holding our money for their use without paying us any interest. We understand the variable rate can and has changed but are certainly not pleased that through some manner of government figuring, we did not receive a penny of interest. Any comments, please?
Ok, what you’ve said is true, but it’s not the whole truth. You descibe bonds (and bond funds) as if their generic entities. There’s a big difference between US Treasuries, municipal bonds, international bonds, and single state or multi-state bonds. All have their differences, risk, returns and violatility, etc.
What’s your point? Something, “like give me your money and let me manage it for you?” Not so fast.
Yes, I agree diversification is a key ingredient of a sound overall portfolio. I would suggest you paint a broader picture of the bond “world”, at least highlight the historic performance versus equities and give the investor a more focused perspective for long-term investing.
I-Bonds– the interest rate is part fixed return and part inflation adjustment. The current fixed rate as of May 2010 is 0.2% (yes that is a “dot 2%”). Then when you factor in the inflation rate at negative 0.7%, there’s nothing to pay bond holders. I guess we should be lucky the govt doesn’t come after us to pay them back for the negative return. Zero percent return is as bad as it can get—talk about looking on the bright side…
Ron M—all good points. By keeping the word count reasonable for a blog, I’m guilty of leaving out some details. My main objective is to help make people aware of a possible bump in the road so they can ask the appropriate questions of their money managers. I want to help people be savvy consumers. I talk to a lot of people through my classes, phone calls and emails. I would say most have the misconception that their bond funds are safe; defined as they fully expect to maintain value or consistently grow their portfolios. The typical comment is “what do you mean they can go down, they pay interest!” It’s this belief, or something in the ballpark, that drives people to buy or keep money in bond funds even when the stock market takes off. In 2009 when the stock market was roaring back, nationally, $600 billion flowed into bonds funds and only $9 billion flowed into stock funds. If what I write about comes true, as so many others, (smarter than me) are saying it will, I’m hoping at least folks will be prepared by asking the right questions and possibly taking action.
Oh and by the way, you give me a chance to explain that we don’t: have clients, develop financial plans, manage money, or sell investment products. We act purely as financial counselors and educators—for free—well with a MOAA membership. Thanks for the input.
O.K. I hear what
you are saying. However,take a crack at this:Have app. 70% in minis and rest in funds- international bonds, international stock, growth, a realty fund, TIPS, small cap, and growth and value. If I understand you correctly I should reduce my investments in bonds and add to by stock funds. I am 88years of age and really do not need the money now. Saving for old person home and the kids.
Thank you
No, I’m not telling anyone to reduce their bond funds. I don’t know anything about peoples’ specific financial situations.
I’m suggesting that if you hold bond funds that decrease in value and that causes you financial pain, you may want to talk with someone to minimize your potential pain.
An once of prevention vs. a pound of cure.
Only you know how much pain you will feel. As you mention, you have issues beyond the values of individual holdings in your portfolio. Namely, you don’t need the money now.
Should you need the money for the “old person home” as you mention, will a bond fund decrease mess with your plans? However, if your minis are individual bonds and not a fund, you may be fine if you are able to hold them until maturity.
I’m just trying to help people think about “what if?” They have to analyze their situation for themselves. I want folks to question whether they need to consult someone before it’s too late.