So far, just about everyone has been wrong regarding interest rates. Just about everyone thought that once the Fed started tapering, yields would rise and bond values would fall. Yet, here we are, half way through tapering, and the yield of the Ten Year Treasury is about 1/4% lower than it was at the end of December 2013.
Bond yields and bond prices have an inverse relationship. As interests rates drop, prices rise and vice versa. The math gets somewhat complicated from there, as maturity dates, credit quality, and other factors will impact the magnitude of the price swings. The bottom line is that unless you expect interest rates to drop from current levels, there is no objective reason to expect the value of bonds or bond funds to rise above their current levels. I for one haven’t met anyone who expects interest rates to fall from here. To the contrary, most people (correctly, in our opinion) expect rates to rise over the next few years – after all, the Fed cannot and will not maintain a zero interest rate policy (ZIRP) forever.
The pressing question is, what happens to your bond holdings if rates essentially stay where they are for the next two or three years? Should investors still sell their bonds? In short, yes – and the sooner the better.
Let’s assume that we, like most, continue to be wrong and interest rates stay at current levels. Given this assumption, your bonds and bond funds will hold their value and you will continue to earn whatever interest the yield of the bond provides. That doesn’t sound so bad, or does it? Yields are low, and such the interest income you earn will continue to be anemic. On the other hand, inflationary pressures are starting to rise, which means that the “Real” income – the inflation adjusted income – you receive is even lower than you think, perhaps even negative. While this risk may not be at the top of your mind, it certainly is on the minds of professional money managers and institutions. If these same managers start to sell bonds even as interest rates remain steady, the selling pressure could impact your bond prices. And since we agree that interest rates are unlikely to drop from here, there is little upside to holding onto bonds.
Lastly, investors should be aware that there are viable alternatives to bonds that can provide a steady income stream, have a more positive long-term outlook than bonds currently have, and depending on the route you chose, may even guarantee the principal. If you would like to learn more about the bonds and bond funds you own, and about alternative approaches, call me at 800-433-0323.
Christopher Hanly is an investment consultant with Gary Goldberg Financial Services in Suffern and can be reached at (845) 368-2900 ext. 247 or [email protected].