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A new client of ours recently came into some windfall. With a desire to act wisely and give his cash an opportunity to grow, he told us he wanted to invest in “something safe.” We asked him if he had any thoughts and he quickly replied: Bonds. Twenty years ago, we would have agreed that bonds were a safe investment. But with interest rates rising as they are today, tomorrow’s “sure thing” is fast becoming today’s risk.
Let’s refer to our new customer as Bob. Bob is a typical retiree. He lives with his wife, who is retired, and their two grown children who have families of their own. Both Bob and his wife receive monthly Social Security payments and pensions from their former companies. In addition, they receive IRA distributions from their retirement savings.
Investing in bonds (or bond mutual funds or bond trusts) to supplement pension and/or Social Security income has been a typical “safe” move for many retirees for more than 20 years. With interest rates falling, seniors who locked in high-interest rate fixed investments received huge 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 view them to be. Let us explain: When interest rates go down, bond prices go up. Now, with interest rates at a historic 45-year low, we think there’s a very good chance that rates will start to climb. The Federal Reserve, otherwise known as “The Fed”, (led by Alan Greenspan) has enormous influence on interest rates. Banks will raise their prime rates in line with the increase in the federal funds rate. Eventually, after a substantial short-term rate hike, we predict that longer-term rates will follow. Shortly thereafter, the bond market would take a hit, and bond prices would be forced in one direction: down.
So here’s what it looks like for our friend Bob: Short-term interest rates are moving higher, while long-term rates have yet to catch up. Long bond yields are in the midst of falling, which means long bond prices are rising due to the inverse relationship between yield and price. There is definitely something wrong with this picture. With interest rates higher, how can bond prices be higher over the long term? Remember what we said about the other important inverse relationship, between bonds and interest rates: It’s only a matter of time before the long bond market corrects and long bond prices start to go down.
If you’re feeling confused about all these relationships, don’t worry…many financial professionals feel the same way. Still, you’re probably wondering: What can I do to protect my investment portfolio? Well, here’s what we recommend:
1) Review your investment objectives.
2) Review your investment time frame.
3) Ask your broker/advisor what are your options for preventing loss of principal and income.
The good news for Bob and others like him is that there are strategies available to help protect his money. One strategy we recommend involves shortening and staggering the maturities of individual bonds so that the money is due regularly. This would allow Bob to regularly assess the interest rate environment, giving him the option of purchasing additional bonds at the current interest rate, or waiting for rates to change.
Because of the widespread confusion and misconceptions when it comes to bond investing, it’s important to remember the differences between the 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 get involved. bond market. But as is the case with any investment, each of these bond investments has its own ratings, risks, performance predictions and principal guarantees. For example, with US government bond mutual funds there is no guarantee of principal.
We’re not suggesting that Bob should avoid the bond market like the plague, only that he should keep a watchful eye on it. There is still money to be made by investing in bonds, but with interest rates rising, the potential for loss has clearly increased. Our goal is to help Bob maintain a lifestyle that includes choice. We want him to enjoy upcoming vacations with his wife, a new car every four years, summer camp for his grandchildren… Bob has worked hard all his life to make these things possible. By watching his portfolio closely and investing carefully in the bond market, we are confident that Bob will be able to turn his plans into reality despite rising interest rates.
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