Daily Gains Letter

Bond Investors Beware: Troubles Ahead

By for Daily Gains Letter | Mar 7, 2013

















070313_DL_zulfiqarThe financial crisis of 2008–2009 was one of the most stressful periods for not only the U.S., but the entire global economy—the financial system was on the verge of collapse. As a result, investors, who dislike risk, moved toward safer assets, such as bonds, because they would rather get a certain lower rate of return than chance taking a loss.

On top of all this, central banks implemented loose monetary policy to provide liquidity to the financial system, lowering interest rates and purchasing troubled assets from the banks.

This phenomenon caused bond prices to skyrocket and yields to collapse. Take a look at the chart below, showing activity in 30-year U.S. bonds.

 

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Chart courtesy of www.StockCharts.com

The 30-year bonds rallied. In October of 2008, just before the stock market started to drop, these bonds were trading below 115. They have come a long way since, and they currently hover around 145—an increase of more than 26%. As the prices of 30-year bonds increased, their yields collapsed as well. Before the financial crisis began, getting a yield of around five percent was normal. Now, the same yields have plummeted, and investors only get a yield of around three percent—a 40% drop.

The Great Rotation

The Federal Reserve has kept interest rates near zero for sometime now—it plans to keep them there until 2015. The idea behind what is called the “Great Rotation” is very simple: bond prices went up, and the yields collapsed. What happens when the Federal Reserve starts to increase interest rates and gets away from the loose monetary policy?

There are misconceptions with investors that bonds are risk free. But the fact of the matter is that they are not risk-free. Bonds carry with them credit risk and interest rates risk. The general rule of thumb when it comes to investing in bonds is that bond prices increase when interest rates decline, and they fall when interest rates increase. Similarly, when a credit rating of a country or corporation is downgraded, it falls in price or value; when a country or corporation’s credit rating is upgraded, its price or value increases.

Lower interest rates have caused investors to take on higher risk. For example, in 2012, companies issued $274 billion worth of junk bonds, which by their very nature are higher-risk default bonds. That amount was 55% higher from a year earlier, according to Dealogic. At the same time, the yields for these kinds of bonds have fallen below six percent. (Source: Hilsenrath, J., and McGrane, V., “Fed Split Over How Long To Keep Cash Spigot Open,” Wall Street Journal, February 20, 2013, last accessed March 6, 2013.)

What It Means for Your Portfolio

Keep in mind that markets are forward-looking. If the Federal Reserve hints to increase interest rates and moves toward the “normalization” of monetary policy, bond prices will decline. As a result, investors who are heavily invested in the bonds market are going to be worse off.

When will the Great Rotation start to happen? It is difficult to predict. Some say that it has already begun, while others say it won’t begin until the Federal Reserve actually raises interest rates. No matter what, investors shouldn’t lose sight of this coming rotation. Investors should focus on capital preservation and diversify their portfolio with different asset classes if bond prices start to plummet.

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