Some Thoughts on Bonds and Interest Rates

rdj meme

In honor of the Avengers franchise having another record breaking weekend, I thought this meme was appropriate after my daily perusal of the CNBC headlines.  Sometimes I just can’t. even. deal.

IMPORTANT! Should investors dump their bonds?

Bonds are the scariest thing out there

Tech is overhyped…except when it’s underhyped

That’s just a few of the fun headlines of today, May 6, 2015.  Bonds have been the topic of discussion for 6 years.  Ever since we started our historic Quantitative Easing programs and zero interest rate policy, we have been talking about the threat of rising interest rates.  And you know what?  It hasn’t happened.  Yet.  In the last 5 days however, we have seen the yield on the 10 Year US Treasury go from 2.04% to 2.249%.  Doesn’t seem like much, but that is about a 10% move.  Looking back 5 years, rather than just 5 days…the yield on May 10, 2010 was 3.57%, which is almost its highest point over the past 5 years. Here’s the 10 year chart for further perspective:

10 year treasury

So what’s all the hype?  Why should investors be “scared” of bonds?  Before answering that, let me get my mantra out of the way, “Be an investor, not a trader and be diversified.”  Fixed Income 101 teaches us that when bond yields go up, the value of a bond goes down and vice versa.  The amount of movement you should feel in either direction is correlated to how long it will be before the bond matures.  The shorter the duration, the less sensitive they should be to fluctuations in interest rates.  The longer the duration, the more sensitive they will be (both positive and negative).

In looking at this chart, do you think holding bonds over the past five years would have been good for your portfolio (remember theory says, rates down, prices up)?  Generally speaking, yes.  Of course there are a myriad of other factors that will affect the bonds price (issuer, credit rating, currency, etc.), but I’m not trying to delve into that today.  According the US Treasury, the average historical yield on the 10 Year Treasury Bond is 6.45%.  If you believe in the theory that all things revert to the mean, then yields most certainly need to rise just to be normal again.  And more than likely that will be the case, which means that bonds could suffer losses in the years to come.  The main questions of course are when will they rise and how fast?  No one knows for certain.  So, how do you invest in bonds in an uncertain market?  The same way you invest in stocks…be diversified.

As we redefine fixed income allocations, we are looking at all aspects of the fixed income asset classes to ensure that we have exposure to many different types of bonds, both US and Foreign.  Bonds are not scary, they are not a bad word, and they should not be sold out of in a haphazard manner.  Certain bonds have historically proven to hold up well during times of rising interest rates, such as bank loans, short term bonds, high yield, floating rate and TIPs, just to name a few.   Our view is that we will continue to stay underweight longer duration bonds and tilt the holdings toward bonds that historically perform well in a rising interest rate environment.  I am of the opinion that you should be prepared for this before rates start to make a big move rather than be left behind.

There are several factors that could cause rates to stay lower for longer than expected.  A couple things that I think can impact rates this year are the strength of the US Dollar and the continued demand from foreign investors.  As Europe embraces their quantitative easing measures, many developed nations are actually experiencing negative yields on their own debt once you factor in inflation.  This is causing them to look elsewhere, and despite all of our perceived problems, foreigners still look to the US for stability.  So while demand continues to outpace supply, rates could continue to stay at these relatively low rates.

Thank you for your time as always.  And I hope after reading this, you’re not making the RDJ face from the beginning.  I look forward to hearing your questions and comments.

All the best,

Carolyn Menker

LPL Wealth Advisor

Williamsburg Financial Group

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