Bond investors must tailor strategies to suit current economic climate

June 1, 2010

If you have any of your money invested in bonds - treasuries, corporates or municipals - you already know that the rules for buying and selling bonds are constantly changing.

If you have any of your money invested in bonds - treasuries, corporates or municipals - you already know that the rules for buying and selling bonds are constantly changing.

Most bond investors fall into one of two categories. First is the buy-and-hold investor who buys bonds solely for the fixed interest they pay. This type of investor intends to hold the bond till maturity and doesn’t care much whether the market price goes up or down during the bond’s lifetime. That pretty much describes my personal bond investment philosophy.

Then there’s the bond trader. This type of bond investor views bond investing much the same as equity investing: enjoying the steady interest payment, but ready to sell at a capital gain if the market price for the bond rises.

Figuring market direction
As most investors know, the market price for bonds tends to increase when interest rates are falling, and decrease when rates are rising. On the surface, that seems simple enough; the problem for both types of investors is figuring out in which direction interest rates are heading and, thus, when to buy and when to sell.

If you’re old enough, you may remember back in 1980 when 30-year treasuries were paying nearly 12 percent. Not only do I remember back that far, I’m one of the lucky people who bought that gem of an investment. While the market price of that treasury gyrated wildly during the past 30 years, I sat back and enjoyed my regular income without any concern for the market’s ups and downs.

But now, the bond is maturing. I’m getting my principal back and now I have to decide what to do with it. Should I buy another long-term bond or invest it elsewhere? Should I invest in another bond as a trader and look for a possible increase in the market price (meaning a drop in interest rates)? This is where those changing rules for both types of bond investors come into play.

Rough time for traders
Bond traders haven’t done so well lately. In the single year 2009, the total return on a 10-year treasury was a negative 9.3 percent. Of course, a buy-and-hold investor like me wouldn’t care about the market price for a bond I already held, but what about a bond investor looking for a place to invest some cash now?

According to many investment professionals, there are signs that long-term interest rates are beginning to edge up. There is also a general feeling that the Federal Reserve will raise short-term interest rates in several modest steps this year. If that happens, bond market prices will decrease (bond prices move in the opposite direction of interest rates) signaling another poor year for the bond trader.

For buy-and-hold bond buyers like me, the question is whether this is a good time to buy another long-term bond. At the time of this writing, the 30-year treasury is priced to produce a yield of 4.56 percent. Not bad, considering the dismal rates currently in effect in most places where you can park your cash. But what happens if the predictions of slowly rising long-term interest rates prove to be correct? That would mean that tying up your money for the long term might not be your best bet.

Predicting the path
In the real world, predicting the path of interest rates is notoriously difficult. In an effort to capsulate the opinions of many experts for this column, I subscribe to a number of financial magazines. That exercise has taught me an important lesson: For every financial guru who predicts that market prices or interest rates are headed up, there is another expert who predicts they will go down.

To me, the best answer to the conundrum posed by that situation is to search for the weight of the majority. Where do the majority of financial professionals stand? Right now, majority opinion is clear; interest rates are set for a slow but steady climb. That appears to be a reasonable prediction, considering the federal government’s massive borrowing needs in its attempt to juice up the economy.

What that suggests is that investing in long-term treasuries may not be the best move at this time. With a slowly improving economy, high-grade corporate bonds are worth looking at. An improving economy should also translate into a more attractive investing climate for municipals.

Looking ahead
If, in fact, our economy is now positioned for a modest but steady improvement, even bond investors may want to take a look at the stock market. The time may now be right for carefully choosing strong companies with a long record of paying - and even improving - dividends. While history is no guarantee of what the future will hold, investing in equities has been the most profitable choice during almost any 10-year period in modern times.

In the final analysis, common sense suggests that any investment portfolio should contain a mix of bonds and equities. Deciding the best recipe for that combination depends on a number of variables including your age and your tolerance for risk. The older you get, the less inclined you should be about “long-term” results. For younger investors, now may be the time to loosen up a bit in your investment philosophy. Information in this article is provided for educational and reference purposes only. It is not intended to provide specific advice or individual recommendations. Consult an accountant or tax advisor for advice regarding your particular situation.