Proceed with caution before investing in bonds

August 1, 2011

If you’ve been following conventional advice on diversification over the past decade, you have a portion of your portfolio invested in bonds of various types. And that’s good. When the equities market tanked in mid-2008, many investors were spared the worst of it by strong returns from their fixed-income investments.

If you’ve been following conventional advice on diversification over the past decade, you have a portion of your portfolio invested in bonds of various types. And that’s good. When the equities market tanked in mid-2008, many investors were spared the worst of it by strong returns from their fixed-income investments.

Most, if not all, professionals still recommend an asset mix that includes fixed income investments as an essential part of every portfolio, but an increasing number of the pros are sounding messages of caution for those who have a significant portion of their portfolios invested in bonds. I agree with their assessment that many people have not yet recognized the increasing risks in the bond market of late. While I don’t foresee the type of declines in bond prices that we saw in stock prices in 2008, I do feel that the overall return on bonds in the near future will be far more modest than those we’ve enjoyed in recent years. Even the possibility of negative returns can’t be ruled out.

Perhaps the most important role that bonds play in an investment portfolio is a reduction in volatility. Because the price of bonds tends to move in the opposite direction of stock prices, a balanced portfolio is less likely to suffer dramatic ups and downs in volatile markets. Of course, when stocks rise dramatically as they have during the past year, bond prices tend to decline. The prime mover in bond prices is the interest rate, which tends to rise as the economic forces that drive up stock prices also drive up interest rates.

Eyeing interest rates
With interest rates at historically low levels as they are now, it is unlikely that they will go lower. In a practical sense, there is no way for them to go but up, and when interest rates go up, the price of bonds goes down. When that happens, the result is a decrease in market value which amounts to a paper loss in principal. If interest rates were to move sharply higher, principal value of bonds could depreciate enough to partially, or even completely, offset interest payments resulting in a negative total return. That dark scenario has happened in the past and it can’t be ruled out in the future, though it is unlikely.

Whether inflation and interest rates are poised for a fairly rapid rise cannot be known for sure, but there are increasing signs pointing in that direction. I do not believe the doomsayers who are predicting rampant inflation, but I do feel that some degree of inflation is inevitable over the coming months, and with inflation comes a drop in bond prices.

With all of this comes the importance of knowing just what you expect from the bonds you own, and what percentage of your portfolio should be invested in them.

In general, the return on bonds comes in two parts: One is the yield (the stated interest rate). The other is the appreciation or depreciation in the principal. When the yield declines as it has been doing in recent years, the rise in principal (the price of the bond) has produced a comfortable overall return. The problem is that with historically low interest rates such as those we are experiencing now, there is little, if any, room for future principal appreciation since interest rates aren’t likely to go lower.

Types of bond investors
Some investors in bonds are traders; they look for principal appreciation (an increase in the bonds’ market value resulting in capital gains). It is those investors who need to be aware of the current dynamics in the marketplace. With interest rates so low and bond prices correspondingly high, there would appear to be little chance for capital appreciation in the foreseeable future. So, if you invest in bonds as a possible source of capital gains, you may want to review your position.

Other bond buyers might be described as buy-and-hold investors. Many retirees, for example, invest in bonds as a source of fixed and predictable income. The interest payment on bonds remains fixed regardless of fluctuations in the market price of the bonds. For those buyers, paper losses or gains are of no concern since they intend to hold on to their investments regardless of changes in market price.

Of course, there is risk even for buy-and-hold bond investors. Although bond defaults are relatively rare, they can and do happen. That’s why bond holders need to keep a watchful eye on the fiscal condition of issuers whether corporate or municipal.

All investments carry risks
None of this is to suggest that you should avoid investments in bonds. Virtually all financial professionals agree that bonds and bond funds have a place in nearly every investor’s portfolio, along with stocks and other investments such as money markets or other cash equivalents. The challenge is to make sure that your allocation of bonds is the result of your personal objectives and your awareness that every form of investment, including bonds, carries an element of risk.

Remember, too, that past performance is no guarantee of future performance. Over the past decade or so, stocks have provided little or no overall return while we’ve enjoyed very high returns on bonds over the last several years. Assuming a repeat performance of that scenario could be a big mistake.