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Don't be like Groucho.
There is a story of the famous comedian Groucho Marx, who while touring the New York Stock Exchange had a floor trader yell out at him, "Hey Groucho, where do you invest your money?" The leader of the Marx brother replied, "I keep my money in Treasury bonds." "They don't make you much money," a trader shouted back. "They do," Groucho said smugly, "if you have enough of them...."
Not All Bonds are Created Equal.
Historically, US Treasuries have provided what some consider "guaranteed" fixed coupon of interest and are called by many as "risk-free assets." However, the associated risks must be evaluated as our world and economic environments change. Often investors fail to decipher the numerous categories of bonds; NOT ALL BONDS ARE CREATED EQUAL. Literally, there are dozens of categories- US Corporate, Tax Free Municipals, US Gov't (notes, bills, bonds), International, Emerging market bonds to name a few; each with different interest rate, credit, currency and liquidity risks.
What is Interest rate risk? Think of bonds like a seesaw. When interest rates go up, the price of bonds typically go down. And vice-versea. If you are forced to sell your bond before its maturity or you purchased at a premium (an amount higher than its issue price) you will receive less principal than you originally invested. What is Credit rate risk? It is the risk that the issuer of the bond will go belly up. The financial health of the issuer is critical.
Do you know what risk your bonds carry?
One of the first rules of investing is to know what you own. Bonds (fixed income) play an important role in a well-diversified portfolio alongside stocks, alternatives, and cash alternatives. Fixed income allocations typically help provide stability to a portfolio (as they are historically less volatile) and regular income. We've enjoyed a 30 year interest rate "tail wind" as US Treasury rates have declined from their 1980s high of 15.32%. This provided between 1980 and 2011 an average annual return of 8.68%*, which is similar to historical equity returns with a risk profile lower than equities during the same time period. I do believe the US Government will continue to pay bondholders interest on their obligations; however the interest rate risk associated with certain bonds, namely long-dated Treasuries, is real. As rates increase over the next few years (no one knows when, how much or how quickly- the Federal Reserve has their work cut out for them), the pricing impact could be substantial to certain bond investors. This is particularly concerning for the more conservative and/or older investor nearing or in retirement, who believes they are in "safe" bonds. While timely payment of principal and interest payments on US government bonds and Treasury bills is guaranteed, the principal value can fluctuate with market conditions and investors could incur a loss of principal is sold prior to maturity.
On a daily basis I review portfolios of clients and prospective clients that are seeking answers to help them understand the true risk of their bonds. Remember, your investment goals should dictate your investments and in this case the type of bonds you should utilize. Maintaining consistent income, stable value and beating projected inflation rates should be areas of focus for your bond allocation.
Don't be like Groucho, get your bonds analyzed by a qualified financial advisor.
Click here if you would like to read more about bonds.
The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Luke Fields and not necessarily those of RJFS or Raymond James. Investments mentioned may not be suitable for all investors. Past performance may not be indicative of future results. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise. U.S. government bond and Treasury bills are guaranteed by the U.S. government and if held to maturity, offer a fixed rate of return and guaranteed principal value. U.S. government bonds are issued and guaranteed as to the timely payment of principal and interest by the federal government.
*1980-2011 Barclays Aggregate bond index, formerly known as Lehman Brothers Agg bond index prior to 2008.
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