Market Digest – Week Ending 6/14
Stocks bounced around as investors struggled to make sense of potential reductions in the Fed’s bond buying programs. A nearly 2% intra-day decline in the S&P 500 on Wednesday was offset by a similar increase on Thursday. The S&P 500 finished the week down 1%. Bonds gained despite nearly universal consensus that interest rates are set to rise.
S&P 500: 1,627 (-1.0%)
MSCI ACWI ex-US: (-1.5%)
US 10 Year Treasury Yield: 2.13% (-0.04%)
Gold: $1,390 (+0.7%)
USD/EUR: $1.335 (+0.9%)
- Monday – Apple announced a new software platform for iPhones and a radio streaming service to compete with Pandora. Microsoft’s Bing will replace Google as Siri’s primary search engine.
- Tuesday – Turkish police stormed a landmark Istanbul square in a bid to evict protestors who believe the government is increasingly heavy handed and threatening lifestyle freedoms.
- Tuesday – Softbank raised its offer for Sprint-Nextel by 7.5% to $21.6 billion.
- Wednesday – US crude oil production rose by more than a million barrels a day last year, the most in history.
- Wednesday – Euro area industrial output unexpectedly increased 0.4% in April.
- Thursday – The US government officially concluded that Syria used chemical weapons against rebels and authorized providing arms to support the rebels.
- Thursday – US retail sales increased more than expected in May.
- Friday – Detroit announced a proposal to pay unsecured lenders less than 10 cents on the dollar as the city attempts to negotiate to see if it can avoid filing for bankruptcy.
We’ve witnessed a spike in fear surrounding bond holdings in the last few weeks. But relatively few seem to understand the risks. Effective duration is a measure which tells you roughly what the price change of a bond will be if interest rates move by 1%. If we look at AGG, a popular ETF which follows the “US aggregate bond market”, the effective duration is just under 5. IEF, which tracks 7-10 year Treasuries has an effective duration of 7.5, while TLT, the 20+year version comes in at 17.
Longer maturity bonds are more responsive to changes in interest rates because you get stuck earning less (or more) for longer. Clearly, what kind of bonds you own matters a lot. If you own the aggregate bond market, even if interest rates spike 2% your losses should stay under 10%. This is before interest payments are considered so the real loss would be even lower. However, if you own 10 year Treasuries the price loss would be closer to 15% and with 20+ year Treasuries you could be looking at a 30% loss in this scenario.
For our clients, based on a risk/reward analysis, we have maintained shorter duration than we normally would for over a year now. But we don’t think it is time to panic or abandon bonds entirely if they are a part of your long term strategy. If you own the right mix, the risk is acceptable and even desirable.
There are two problems with trying to avoid any interest rate risk. First, even if you’re right and rates rise, it is very difficult to know when to get back in. If you sit in cash too long you will get passed by eventually due to collecting less interest. Over very long periods of time bonds provide superior returns to cash. Second, and more important, you may not be right. The investment world is littered with those who have lost money or missed out by being bearish on bonds in the last few years.
Just because the Fed stops buying bonds doesn’t mean interest rates must go up. The capital markets love to prove people wrong. Whenever there is near universal consensus something will happen, as there is now with bond prices, it is wise to be wary.
Craig Birk, CFP®
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