Bonds: The Forgotten Stepchild

Recently, we posted an article about being "Tax Smart Year-Round." To help accountants help their clients, we're posting occasional investing pieces to show that tax time is not the only time to think about investments. Daniel G. Mazzola, who is both a CPA and a Certified Financial Planner, gets the ball rolling with a discussion of bonds.

Typically when the stock market experiences a day of plunging prices, the mainstream is all over it with photos of a frantic NYSE trading floor. Bonds garner no such interest; stock losses have a direct correlation with our sense of economic prosperity, while a drop in the bond market does not have the same visceral effect. We all know that when interest rates rise, bond valuations fall – but that's counterintuitive to newbie investors. Accountants who have a sense of fixed-income basics are in a position to guide clients.

Let us use an example of an individual who buys bonds to illustrate the relationship between interest rates and bond prices. "William" bought a bond two years ago paying 5 percent. During the past few months interest rates have been increasing, and newly issued bonds are yielding 6 percent. William’s bonds paying 5 percent lose their appeal in a market of 6 percent bonds. Who wants a 5 percent bond when they can receive a virtually identical one for 6 percent? To attract demand, the price of William’s bonds would have to be discounted to match the total return provided by bonds at prevailing interest rates of 6 percent.

If the bond market was as part of the national fabric as the stock market, it is likely we would have seen an image of an anguished bond trader in late May 2013, because at that time investors began liquidating their bond holdings with alacrity. A bond sell-off was not unexpected, given how popular fixed income vehicles had become with investors shaken by the events of 2008-09. Most strategists expected a gradual transition out of bonds, allowing interest rates to slowly drift upwards.

But when Fed Chair Ben Bernanke suggested that the strength of the economy might allow the Fed to curtail its bond-buying program, waves of selling convulsed the bond market. An important and necessary outcome of the Federal Reserve Bank’s demand for bonds was that prices remained high and rates stayed subdued. “Tapering” – that is, fewer bond purchases – would reduce prices and result in increased rates. Bernanke’s intimation drove the value of 10-year Treasury notes down over 10 percent in a month. This is the equity equivalent of watching the Dow fall by 1,500 points, which would've led to major headlines.

While rates have risen for relatively brief periods during the last few decades, most notably in 1994, financial professionals assert that the conditions are in place for a prolonged interim of significant rates increases, which we have not seen since the early 1980s. Howard Ward, chief investment officer of Gamco Investors, asserts that “the lost decade of bonds has begun. Stocks are likely to be the asset class of choice for the next 10 years, now that the tide has turned and the economy is doing better.”

Other strategists counter that losses in the bond market in May/June 2013 were driven more by fear than a rational assessment of interest rates and bond values. They contend the overall economy is not improving, citing consumer retrenchment, weak commodity prices, and increased government regulations as factors leading to slower economic growth worldwide for many years to come. In such a sluggish environment, bonds would maintain their values and continue to meet investors’ expectations.

There is no way to eliminate all the risks that rising rates pose for bonds, but they can be reduced by carefully tending to the duration of bond holdings. Duration is a measure that reflects a bond’s price sensitivity to rate movements. A bond with high duration will react sharply to interest rates fluctuations, whereas the impact on a bond with lower duration will be less acute. A 30-year zero coupon bond provides a prime example of a bond with extremely high duration. Its investor receives no interest payments and will not see a return of principal for three decades. If rates go up, the bondholder cannot re-invest interest into newer bonds to take advantage of rising rates. As for why someone would buy long-term zero coupon bonds, they are appropriate in a climate of high rates. Just ask the person who bought 30-year zero coupon Treasury bonds yielding 14 percent in the early 1980s.

Investors will need to carefully navigate both the stock and bond markets when interest rates start to rise, and then process the growing realization that they can, in fact, lose money in bonds. Rising rates will have an adverse effect on any investment vehicle with a fixed coupon, even those with a set maturity date and guaranteed return of principal. Knowing that you will receive your money back in a few years may be a small comfort when you receive brokerage statements indicating (unrealized) losses on bond holdings.

Bonds remain an integral part of any diversified portfolio; however, as they generate income, help reduce overall risk and provide the holder with an ability to plan for a future need.

About the author:
Daniel G. Mazzola, CPA, CFA, is an investment advisory representative with American Portfolios Advisors Inc. He is a Chartered Financial Analyst, Certified Public Accountant, and Certified Financial Planner.

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