Bonds May Be The New Stocks

Last week it happened. A new signal presaging a change in the direction of interest rates appeared to all who were watching. The change Im talking about is the beginning of the slow inevitable rise in interest rates. Yields on the benchmark 10-year U.S. Treasury note now stand above 2.1%still low by historic standards, but nearly half a percentage point higher than at the start of May. Rates on 30-year fixed-rate mortgages rose a hair above 4%. Six months ago, they were below 3.5%. Now, there is no need to panic, last week was the beginning. And as with many beginnings, this movement may quickly reverse, putting last weeks move into the category of mere fluctuation versus the beginning of a trend. And while no one can be entirely sure, including your humble host, I want to help you prepare for what will be the inevitable rise in rates and discuss how it will have a significant effect on your portfolio value and future rates of return. The value of a bond depends on three important factors: 1) the maturity date of the loan; 2) the stated interest rate relative to prevailing interest rates and 3) The quality of the bond, reflecting the borrowers ability to pay back the principal and interest. Bond Pricing If I bought a $10,000 treasury bond last week maturing in 2023, paying 1.5% interest I would have found after only one week the bond value declining to $9,460, or by -5.4%. All this because of the dramatic effect of last weeks rout in the bond market. And as this phenomenon becomes more apparent to bond participants---whether you own individual bonds or bond funds in your 401k, the next time you look at your statement, the change may shock you. This change may act as a wakeup call to those who thought their bonds were safe and a protection from unwanted risk and volatility. At the same time investors will notice a large increase in the value of their stock portfolios. The rise in stocks started in earnest at the beginning of the year and participants will notice the disparity. This may cause the beginning of the big shift from bonds to stocks pushing bond prices even lower. So, it is important to understand the mechanism behind the change in value of your bonds and what you can do to prevent it and reduce the change as prudently as possible. Heres my best example of why bond prices change.

Suppose, once again you had a $10,000 bond paying 3% or $300 per year in interest. Sometime later interest rates rise to 6%. You now find yourself having a bond yielding 3% when everybody can now get a similar bond at 6%. What would be the value of your bond if you wished to sell it? If you wanted to liquidate, you would be forced to sell your bond for 50 cents on the dollar. This way a new buyer could buy two of your 3 percenters for the same cost as one 6 percenter. You can see under this scenario how the market value of your bond went down (by 50%) do to an increase in prevailing rates. This correct financial term for this phenomena is Interest Rate Risk. This happened a few years ago to the worlds biggest bond fund - the PIMCO Total Return Fund which had a yield of roughly 3%. Between November 4th, 2009 and November 15th, 2009, interest rates rose causing the price of this fund to fall from $11.77 to $11.51 per share--A decline of $0.26 or 2.2%. Had you bought this fund on November 4th, your expected annual yield from income of 3% would have been offset by a loss of principal value of 2.2%, leaving you with only a 0.8% return. Back then this decline turned into an isolated event and did not result in a rising interest rate trend. As a matter of fact, bond yields declined after that, allowing for this fund and all others invested in bonds, to experience capital appreciation on their bond holdings. How do bonds appreciate? Think of my previous example in reverse. If rates at which I bought my bond were 3%, and rates declined to 1.5%, I could expect my bond to go up dramatically in price and perhaps double, if I had a bond with a very long maturity. Bond Investors Take Note As I have previously said, after 2008, many investors closed their stock positions and moved all their money into bonds, thinking bonds are safer. Well, hopefully now you see that bonds too can carry significant risk which may result in sizable loss of capital. I dont want to scare you away from bonds. They are an important element of most portfolios. I just want you to be aware of the risks and rewards so you dont overly load-up on any one type of investment. Remember : 1) All investments have risks and rewards and its up to you to accept or reject them with the knowledge you have gained and 2) to continually seek balance in your portfolio.. Last weeks wake-up call means it is time to focus on your bond investments and brush up on bond basics so you earn the best thats available to you in a given market environment. .

Steve Pomeranz is a Managing Director for United Capital Financial Advisers, LLC, "United Capital", and owner of On The Money. On The Money is not affiliated with United Capital.