By Ben Esget
In my experience, investors have a very limited understanding of bonds.
Generally speaking, bonds come with an attached yield or interest rate, duration and a credit rating. Investors must navigate all three when analyzing a bond portfolio and each element has its own set of risks.
Many investors undermine the risks associated with bonds, because the United States has had an unprecedented bull market in bonds since Paul Volker decided to put an end to inflation and pushed interest rates to more than 15 percent. Ever since then, interest rates have declined like clockwork pushing returns.
The chart below from accounting firm MCGladrey shows this trend throughout history.
Today, interest rates on T-Bills are approaching all-time lows, so investors must wonder what happens if rates reverse like they did in the 1940s.
As a rule of thumb, investors will lose 1 percent of principle for every year of duration on their bond portfolios. For those who do not understand, bonds come attached with a period in which holders will pay off the bond, similar to a mortgage.
For example, a 1 percent rise in interest rates on a bond portfolio with a 5 percent yield would be expected to lose at least 5 percent.
Given that yields are at all-time lows, many investors believe there is a high chance of interest rates going up over time and have thus decided to weight their portfolios toward lower duration instruments.
Yield is the payment that a company pays investors for the use of their money. This is akin to the payment on a mortgage.
One of the hardest parts of analyzing yield in today’s environment is that yields are being artificially held down by the Federal Reserve. Determining the correct payment for the risk you are taking is very difficult to analyze.
The final paradigm of bonds is credit rating. Here again, the paradigm is difficult.
We live in a world of skewed risks and increased defaults. Credit-rating agencies have misunderstood risk from government-bond risk to collateralized debt obligations. Understanding the actual risk associated with a bond portfolio is very difficult today.
Putting it all together, investors must navigate risk on three levels: credit risk, duration (interest rate) risk and getting paid a reasonable yield for these risks.
In my opinion, leaning toward term bonds while balancing credit risk and still maintaining a reasonable yield is the bond game today. It is not easy and most likely a bond index will not fulfill these goals.
Today’s bond world is like balancing a tripod. You need to make sure all three elements (legs) are even.
(Click chart to open)
Ben Esget is the president of WealthMark LLC, an investment firm in Bellingham. His columns appear on BBJToday.com every other Wednesday. Esget also runs the finance blog Outsider-Trading.com, in an effort to level the playing field between Wall Street and Main Street. Contact him at 360-734-1323 or firstname.lastname@example.org.
Author’s note: The information in this column should not be construed as investment advice. Everyone’s goals and investment portfolios are unique. Please contact a financial adviser or an accountant for your particular needs.