What should you do, if anything, about sinking bond prices?

Seeking Alpha’s Wall Street Breakfast reported last Thursday morning that “bond yields continued their sell-off as the six-week bond rout rumbled on. Further United States Treasury yields rose as high as 2.425 per cent before retreating.”

There are a number of investment and economic reasons that bond prices and yields are volatile currently, such as worries about Eurozone deflation, and the Greek debt repayment negotiation problem.

But possibly the most important to us on the Atlantic side of the ocean is that the United States Federal Reserve may start to raise interest rates before the end of the year. Of course, no one knows this for sure, but that generates uncertainty in and of itself.

If market interest rates respond with a rally upward, then new bonds issued into capital markets will carry a higher coupon interest rate, making existing bonds with lower rates of interest less attractive. When any product is less desirable, a sale discounted price opportunity can exist. Thus, the price of the lower interest rate bonds in the market now will drop — meaning that the investor can buy the lower interest rate bond at a discount. The lower the price of the bond to the coupon interest rate the greater the bond yield.

Small investors and institutional managers will consider selling lower interest rate bonds as a management strategy before their value drops too far into negative territory, then possibly stay in cash before reinvesting in higher interest generating bonds or other securities.

What does this mean to you, the ordinary investor?

Your Bermuda national pension fund probably contains a percentage allocation to bonds, unless it is highly aggressive. You may own a bond mutual fund or a balanced mutual fund with an allocation to bonds.

Dropping bond prices — and the investment market media hype about negative returns for bond fund investors — can be very unsettling. The financial gurus often fail to mention that for many bond investors these are negative returns — on paper. And that bonds held to maturity will return 100 per cent of the principal (high grade that is). High-yield bond are much higher risk; often called junk bonds, they may not always return full principal-invested value or even may default.

They also almost never mention that fact that small bond investors do not spend their days buying and selling bonds on the open market, like institutional investors, but are more interested in the interest income received and holding for the long term. Rising interest rates are actually good news for bond investors if they are investing for the long term and reinvesting their income. As each tranche of interest income is received, new bonds can be bought with higher coupon rates. This is called bond laddering — that encompasses bonds with different maturities and different interest rates. More on laddering in next bond article at end of the month.

On the other hand, increasing rates is not good news for investors who may need their money back within a shorter time frame.

It really does boil down to a question of liquidity, personal financial goals, and really understanding how these investments work in different interest rate environments.

Investors buy bonds and bond funds for three primarily different reasons. How rising rates may affect you depends on which category you’re in.

BONDS FOR INCOME

Some bonds may be cheap right now, selling for less than 100 per cent on the dollar. Everyone loves a bargain. If you pay say $950 for a $1,000 face value bond and it has a good coupon rate, say 3 per cent (or more depending upon the credit worthiness of the issuing company or government), you will receive that coupon rate over the life of the bond. At maturity you will make an additional profit of $50 when the principal is returned to you. What is wrong with that?

LIQUIDITY

Bonds and bond funds should match your financial goals. If you will need liquidity in the next couple of years, you may be better off moving into a cash position. Or better yet, building up several years of cash / term deposits before you invest any additional personal income into capital markets.

ASSET DIVERSIFICATION

Remember that markets are fickle. In returns, generally, stocks beat bonds (and inflation), bonds don’t beat inflation but do beat cash. When stocks are taking a terrible valuation beating, investors flee to high-grade bond safety, and vice versa. Your pension allocations are fully diversified based upon your investment profile and bonds are a component of that portfolio. Truly, you need them all in your fully diversified portfolio because as Forest Gump’s mother always said, “Life is like a box of chocolates, you never know what you are going to get.” Ditto for global capital markets.

Everything changes; everything stays the same. Capital markets go through cycles. Interest rates rise, interest rates fall, and the process of investing carries on.

It is telling that I actually wrote this original article more than ten years ago — about the same bond volatility and basically the same concerns — that US Federal Reserve was indicating interest rates would rise. I have updated it to reflect the current investment climate.

If you are not sure of what you should do, don’t be impulsive in selling and don’t try to outguess the market. Greater men and women than you or I have tried and failed. Read everything you can. Talk to an experienced qualified investment manager.

The Vanguard Group has a good website explanation about bonds in their news centre section called “Reducing Bonds. Proceed with caution.” Check it out. https://personal.vanguard.com/pdf/s704.pdf

Martha Harris Myron CPA PFS CFP JSM, Masters of Law: International Tax and Financial Services. Appointed to the Professional Tax Advisory Council, American Citizens Abroad, Geneva, Switzerland. The Pondstraddler* Life™ Consultancy provides cross border financial planning for internationally mobile individuals and their businesses residing, working, crossing borders, and straddling ponds in the North Atlantic Quadrangle. Specific focus on residents of Bermuda, the premier international finance centre.

Contact: martha@pondstraddler.com