Taking a Second Look at Bonds Should Worry Investors

Inflation and interest rate risks remain a major concern, and here's why

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Taking a Second Look at Bonds Should Worry Investors

Risk #3: Loss of resale value in the aftermarket. Let’s take a look at corporate bonds to better understand this concern. Currently 10-year AAA corporate bonds are paying 3.75%. If we invested $10,000, we would receive $375.00 in interest every year. Now suppose the market interest rates change, which they will. Should we want to sell our bond in the aftermarket, we have to adjust our aftermarket selling price to the competition—meaning bonds offering the current market interest rates.

Should interest rates drop, our bond will be worth more because we have a higher-than-market rate and should receive a premium. If interest rates rise, our resale value drops and we are left with two choices: we can sell the bond at a discounted price, or we can hold it to maturity and receive interest at a below-market rate.

How radically could our resale value drop? The term used for calculation is “duration.” The duration of a 10-year AAA bond paying 3.75% interest is currently 8.38. In the resale market, it serves as a rule of thumb. If interest rates rise by 1%, you can expect to discount your bond by $838.00 to sell it—that is over two years of interest payments. By comparison, if there were only five years remaining, the duration drops to 4.58, meaning you would have to discount it by $458.00.

Can anyone guarantee interest rates, which are historically low, are going to remain that way for the life of a long-term bond? With the Federal Reserve flooding the banks with money, how much longer before our international creditors are going to demand higher interest rates to hold US dollars? Safety is the absence of potential loss or harm. It’s clear that potential for loss or harm is present, not absent, in today’s world.

Grade for Risk #3: FAIL.

Combining inflation and interest-rate risk. The real challenge is guessing what might happen to inflation and interest rates during the life of the bond. Here is what happened to inflation during the Carter years:

  • 1977—6.5% inflation
  • 1978—7.6% inflation
  • 1979—11.3% inflation
  • 1980—13.5% inflation
  • 1981—10.3% inflation

What happened to interest rates? The prime rate reached 21.5% in December 1980, the highest rate in US history. If you held long-term bonds prior to 1977, then you had to choose between large inflation losses or huge losses if you had tried to liquidate your low-interest bonds in the aftermarket. Seniors and savers attempting to protect their nest eggs are trying to avoid those sorts of catastrophic results.

At the time, investors buying higher-than-inflation interest rate bonds did very well. The current 3.75% rate is well below the interest rates that were available during that time frame. When interest rates rise well above the inflation rate, the safety scales will once again tilt in our favor.

Don’t let the high rating or federally insured label fool you. If a broker or fund salesperson is trying to sell you safe investments, ask them to clearly define the word “safe.” Does it include all three factors mentioned above?

Don’t judge a bond on the credit rating alone. While you may have an almost 100% probability of return of your money, the potential for inflation loss or early liquidation losses must be factored into your investment decisions.

Why have bonds changed so radically? A decade ago, bonds were a central part of any retirement nest egg. A retirement portfolio would not be complete without a balance of top-quality Treasuries and corporate bonds paying 6% or more. They did much of the heavy lifting and were considered the epitome of safety—particularly when compared to the volatile stock market.

Negative interest rates, however, have significantly elevated the risk on low-rate, fixed-income investments. As a result, investors are forced into the stock market in order to protect their nest eggs. Swinging the pendulum too far in the other direction is just transferring our capital from one high-risk investment to another. At the end of the day, we still have too much risk. There is a better way.

What is our winning strategy? Just because high-rated, low-yielding, long-term bonds are surefire losers in today’s market does not mean we should avoid bonds all together. Quite the contrary, we just have to use the right criteria to evaluate and pick them. There are literally thousands of types of bonds available in the market today, and many of them can fit nicely into your retirement portfolio.

Our team of analysts has done their homework and found excellent opportunities that meet all three checkpoints with excellent passing grades. How? By following Doug Casey’s rule to look where no one else is looking.

You can learn more about our “winning approach” by downloading your free copy of our timely special report, Bond BasicsClick here to begin reading your copy now.


Article printed from InvestorPlace Media, http://investorplace.com/2014/02/second-look-bonds/.

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