Your Money: Before Dumping Bonds, Consider Why You Have Them

You can hardly blame them. Investors have been fleeing bonds in droves; a record $76.5 billion poured out of bond funds and exchange-traded funds during the month of June through Wednesday. That exceeds the previous record, according to TrimTabs, when $41.8 billion streamed out of the funds in October 2008 and the financial crisis was in full force.

But the rush for the exits really means one thing: investors are betting that interest rates are about to begin their upward trajectory, something that’s been expected for several years now. Their cue came from the Federal Reserve chairman, Ben Bernanke, who recently suggested that the economic recovery might allow the central bank to ease its efforts to stimulate the economy. That includes scaling back its bond-buying program beginning later this year.

So the big fear is that interest rates are poised to rise much further, driving down bond prices; the two move in opposite directions. A Barclays index tracking a broad swath of investment-grade bonds lost 3.77 percent from the beginning of May through Thursday, according to Morningstar. United States government notes with maturities of 10 years or longer, however, lost an average of 10.8 percent over the same period.

Making a bet on interest rates is no different from trying to predict the next big drop in stocks, or jumping into the market when it appears to be poised to surge higher. These sort of emotional moves are exactly why research shows that investors’ returns tend to trail the broader market. And it’s also why many financial advisers suggest ignoring the noise, as long as you have a smart assortment of bond funds that will provide stability when stocks inevitably tumble once again.

“It’s a futile game to base portfolio moves on interest rate guesses,” said Milo Benningfield, a financial adviser in San Francisco. “We don’t have to look any further than highly regarded Pimco manager Bill Gross, whose horrible interest rate bet against Treasuries in 2011 landed him in the bottom 15 percent of fund managers in his category that year. Investors should take a strategic approach designed around the reason they hold bonds — and then sit tight whenever hedge funds and other institutions shake the ground around them.”

The main reason longer-term investors hold bonds, of course, is to provide a steadying force. And though today’s lower yields provide less of a cushion — the 10-year Treasury is yielding about 2.5 percent — bonds still remain the best, if imperfect, foil to stocks.

“The role of bonds in a portfolio has always been to be a ballast or a diversifier to equity risk,” said Francis Kinniry, a principal in the Vanguard Investment Strategy Group. “And that is very true today. Yields are low, but this is what a bear market in bonds looks like.”

So, yes, losses are indeed more probable than they have been in recent years. From 1976 through Jan. 31, 2013, high-quality bonds yielded an average of 7.3 percent, according to a recent Vanguard study, which provided a nice cushion. For instance, if you had a portfolio of 60 percent stocks and 40 percent bonds — and stocks fell by 20 percent — the overall portfolio would have lost 9.1 percent. If the market plummeted 40 percent, the entire pile of money would be worth 21 percent less.

The situation is a bit different now. Assuming a more conservative average return on bonds of 1.9 percent — a reasonable estimate based on bond yields now, according to Vanguard — the same 20 percent drop in the stock market would cause the overall portfolio to decline by about two percentage points more, or 11.2 percent. If the market plummeted by 40 percent, the portfolio would lose 23 percent.

“Investors have been conditioned by higher bond yields going into both bear markets in the last decade to believe that bonds will substantially offset stock declines,” Mr. Benningfield added.

So perhaps the loss from the bonds somehow feels worse because it’s not something investors are accustomed to. And the memories of the stock market collapse of 2008-9 are still fresh enough. “People are using adjectives like ‘blood bath’ and ‘devastation,’ but we are talking about a negative 3 percent return,” said Mr. Kinniry, referring to the Vanguard Total Bond Market Index fund, which is down by that amount year-to-date.

Even the big bond market sell-off in 1994, which many refer to as a “massacre,” doesn’t seem quite as violent as that moniker suggests. As Mr. Kinniry points out, the same index fund lost 5.3 percent that year, after interest rates spiked by 2.83 percent. If the same sort of situation were to play out now, he said the returns would be significantly worse because bond yields are lower than they were back then. “You might lose about 8 percent,” he said, adding that losses could be deeper depending on how quickly rates rose, among other factors. But typically, “we’re talking about single-digit losses.”

Still, some advisers suggested taking a closer look at your overall allocation to stocks, particularly if you’re not well diversified, since bonds will provide less protection.

For most investors, holding bonds through low-cost index funds remains the most prudent course. People who invest in individual bonds don’t have to worry about fluctuations in their price because they can continue to hold the bond and collect their interest payments until maturity, at which point they’ll collect its face value (unless, of course, the bond issuer defaults). But you need to have a good pile of cash — some experts say $500,000, even more — to assemble a diversified portfolio of municipal and corporate bonds (though you don’t need quite as much for Treasuries, since they’re backed by the government).

You can figure out how sensitive your fund is to interest rates by looking at its duration, which essentially measures how long it will take to receive all of your money back, on average, from interest and your original investment. Generally speaking, for every percentage point that interest rates rise (or fall), a bond’s value will decline (or increase) by its duration, which is stated in years. Bond funds with shorter durations are less susceptible to interest rate risk — the faster a bond matures, the thinking goes, the more quickly you can reinvest the money at a higher interest rate.

That means a fund like the Vanguard Total Bond Market Index fund, which has a duration of 5.5 years, would decline by about 5.5 percent. But since the fund also pays investors income — it has a yield of about 1.7 percent — it would actually only post a total loss of about 3.8 percent. (Future returns would be one percentage point higher, too, thanks to the rise in rates).

But if even that feels too risky, experts say you can put some of your bond money into a diversified index fund with an even shorter duration. The trade-off, of course, is that you will earn less income. That might not matter once you remind yourself why you own bonds at all.

Article source: http://www.nytimes.com/2013/06/29/your-money/before-dumping-bonds-consider-why-you-have-them.html?partner=rss&emc=rss