Broker Check

As Promised, Some Thoughts on Bonds

June 26, 2020

Today’s topic will be on bonds – I know I’ve been promising this for a while, but it’s actually been a bit difficult to put my thoughts into a relatively short email.   I could probably write a book on this topic so condensing it to a few paragraphs isn’t easy.     But before I do get into the bond discussion I want to mention that at BrightPath we are working to get back as close to normal as we can.    The office has remained open for anyone who would like to meet in person, but if you prefer we can meet via Zoom or via a telephone call.    We have been working incredibly hard behind the scenes to implement several new software packages, bring in our two new advisors in Raleigh, and otherwise improve a number of our processes at BrightPath.   We will be contacting all of our SSG and Eqis clients over the next month or two to set up annual reviews, and we look forward to seeing all of you (or just hearing you if you prefer a phone meeting!).

On to bonds…..   As most of you know, bonds have typically been utilized to add an element of safety in a portfolio.    For the majority of advisors a standard portfolio is based on a 60/40 split – 60% into equities and 40% into bonds.    And make no mistake, this type of portfolio does generally reduce the overall volatility of the portfolio as bonds are less volatile than stocks overall.   It is very important to understand, however, that bonds can have significant risks – after all, as I like to say – if you had an Enron bond, guess how much money you have?    But more so than default risk bonds are faced with interest rate risk.    As interest rates increase, the value of a bond will fall.    The rule of thumb is that for every 1% increase in interest rates a 10-year bond’s value will fall by 10%.    So if you have a new 10-year $10,000 bond paying 3%, and interest rates rise by 1%, your bond would have a value of $9,000.   This is because no one wants to buy a 3% bond when they can take the same $10,000 and buy a 4% bond.   Obviously that’s simplifying matters but it’s a good generalization.   

A large number of investors may understand this concept in theory, but haven’t spent much time worrying about it.    After all, interest rates have somewhat steadily declined over the past 40 years, so longer-term bonds have increased in value rather than decreased.   What has happened over the past year or so really illustrates this well.    Just when we thought interest rates couldn’t get any lower, the Fed lowered rates to almost zero.    So those investors holding bonds have seen a jump in value of those bonds, and it came at a great time.    It helped to offset some of the volatility hitting the stock market during this pandemic.  But if interest rates are at almost zero, what will happen when they start to increase?   When the economy truly starts to recover from this pandemic, inflation is always a risk, and rates will rise.   

As a side note, I often hear the argument that an investor doesn’t have to sell their bonds and so the fluctuating value doesn’t matter.    The interest rate is what matters, and as long as the bond doesn’t default the investor can simply be happy with their 3%.    And that’s true, but we are forgetting a few things.    First is opportunity cost – what is the investor giving up if they are getting 3% and everyone else is getting 5%?    Multiply that difference by 40% of your portfolio and you begin to feel the pain.    In addition, the investor must truly understand the lack of liquidity inherent in a plan to hold bonds until maturity regardless of anything else.     If you have read my “Risk Management in Retirement” white paper you will understand why it is critical have a safe source of funds ready to utilize in down market years.    Finally, if you own bond funds you do not have control over how long each bond is actually held.

Furthermore, the volatility in the market has most likely resulted in an increase in demand for bonds as people are worried about what will happen with stock prices.    High demand can also contribute to higher prices.   Bonds have greatly benefited from the idea that they are the only alternative to stocks, so when investors want out of the stock market they turn to bonds.    Since most investors are very short-term focused, they see the recent jump in bond prices as a good thing and want in.    And when they feel we’ve truly gotten past the worst of the pandemic will be trying to offload bonds to get back into the market.    Those are whom I like to call the “buy high sell low” investors.  

To summarize all of this…  I believe the future return potential for bonds is extremely low.    I believe that if you are holding a significant amount of bonds you may want to consider other options.    I’m not suggesting everyone dump every bond holding, but it’s worth an analysis of your options.    Let me know if you would like to discuss your bonds and what your options are for diversification.

In the meantime, I hope everyone is staying safe.   I know we all can’t wait for life to return to normal but I also think it’s going to be a while.   But don’t let that stop you from contacting us for a meeting – we are here when you need us.