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Beware of Bonds

Stock investors are spooked. The last decade was a wild ride accompanied by a modest rate of return. Meanwhile, bond owners have been very happy for a long time. Happiness breeds complacency. But bonds can be a lot more risky than people realize.

When people get nervous about, politics, the economy, or just about anything else, money pours into the safety of US Treasuries, pushing prices up and yields down. The recent financial crisis and subsequent aggressive Fed policy have left US Treasury yields near all-time lows. Yields can’t go much lower, but they can rise sharply, especially if the Fed slows or stops its unprecedented bond buying programs. The price of bonds is inversely correlated to interest rates.

In other words, it is a dangerous time for bond investors.

If 10-year rates rise to 4% (where they were a few years ago), 10-year Treasuries will lose over 20% of their value.

If long rates rise to 5%, owners of 30-year Treasuries would lose more than 30%. A return to the 8% to 10% interest rates of the early 80’s would result in losses over 50%. 

When you buy bonds, you are lending money to an entity in return for a fee (i.e. interest) and a promise to pay you back (i.e. principal). With Treasury bonds, it’s safe to assume an extremely low probability of default. The US government can always print money to pay its debts. But this can fuel inflation and erode the purchasing power of bond holders.

This scenario would not matter as much to holders of short-term debt, but it would severely hurt those with longer duration bonds.

Bonds remain an important part of most portfolios. They play a critical role in providing income, stability and diversification. But they are not riskless. In our managed accounts, bond positions consist of mostly short and intermediate term issues, which should help mitigate the impact of rising rates. And if we are wrong, missing the extra yield offered by long term bonds won’t cost much. We also diversify across all parts of the fixed income universe, including Inflation Protected bonds.

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