Bonds and bond funds are key components to a portfolio. They typically provide stability and are critical for RIF’s which require regular withdrawals. However, medium to long term bonds are sensitive to rises in interest rates and can decline dramatically if interest rates rise sharply – especially corporate bonds. The following article explains why I’ve been recommending a move to funds that purchase shorter term bonds to protect portfolio values.
One of the most confusing explanations is the inverse relationship between prime interest rate and the values of bond and bond funds. For the detailed explanation go here:
We haven’t seen a sharp rise in interest rates in over 15 years – in fact interest rates have declined and stayed low for a long time – but all things go through cycles.
The issue is liquidity – or the availability of money for borrowing purposes. There’s lots of it, especially in the US and some European countries, because they’ve been printing it! Lot’s of liquidity means low interest rates, which allows businesses to borrow and expand. Too much liquidity creates inflation – which is too much money chasing too few goods. As more money is available to buy fewer goods in a recovery, prices go up with demand and inflation is the result. Controlling inflation is a mandate of all governments and raising interest rates is the medium.
The US has not yet turned off the money machine because liquidity is driving their recovery but it will end soon. Some analysts are suggesting the US is not reacting fast enough and should have reduced liquidity months ago. This is one reason we are seeing a rise in prices of certain goods – commodities for one. When liquidity decreases (and it will!) interest rates will rise and the value of long term bonds will fall – the more dramatic the rise the more dramatic the fall. Now if you held those bonds to maturity – you’ll get what you invested plus the interest rate. But individual bonds and bonds held in a fund have to be priced on a daily basis – and will decline in value with rising rates depending on the amount of longer term bonds in the portfolio.
This happened from 1994 to 1995. The US decreased liquidity by raising the interest rates on their government bonds (US Treasuries) from 3.25% to 6% over two years. All fixed income investments: bonds, dividend paying utility stocks, REIT’s dropped in value. The longer the maturity of the investment, the farther it dropped!
Although I don’t believe rates will rise significantly anytime soon, any rise will impact long term bonds. So, the message is – stay primarily in short term fixed income products (or bond funds that do this for you!) until we get through this current liquidity cycle.