We boomers have always known bonds (or fixed income investments) as “safe” investments with steady returns. Bonds represent a loan of money with a promised return over a specified time. At maturity the initial loan is to be repaid. However, very few of us buy individual bonds today – inventory is scarce and prices are high for the average investor. Professional investors (such as mutual fund managers) are offered bonds at the best prices because of volume. As individual investors, we typically invest in small amounts and regularly, so a bond mutual fund is a convenient option. Bond fund managers buy bonds with varying maturities and from a number of different sources to increase returns and manage risk.
Why this is important – Fixed income investments are important in most portfolio’s and especially if you are withdrawing. Returns on bonds have declined dramatically and are expected to be low in the coming years and are at risk of declines depending on what happens with prime rates. This means holding the traditional 20-40% in fixed income investments in your portfolio will lower your overall returns. Some allocation to fixed income is important as we approach retirement, so we need to understand the risks.
With prime rates expected to be low for some time, returns on the least volatile government bond investments are expected to be low as well for the foreseeable future. In 2012 government bonds returned less than 3%. Bond fund managers are increasingly going to corporate and global bonds for better returns. Of course, the risk of default increases. Greek bonds were available paying 12-22% last year!
Whether you buy an individual bond or a bond fund, the market value of a bond at any point in time is inversely correlated to prime interest rates. When prime goes up, the market value of every bond held in a portfolio goes down. The simple explanation is, bonds offered after a rise in prime will pay a greater interest rate, so the older bonds (which pay a lower rate) need to decline in value so older bonds are priced in line with new bonds.
Money invested in fixed income investments (bonds or bond funds) is negatively impacted when prime rates increase. The shorter the maturities – the less the impact in a rising prime interest environment. With prime likely to start increasing in the coming years, bond investments need to be managed carefully.
This article reviews the current fixed income market, reviews flows of money into bonds, the impact of rising rates and the steady decline of bond returns:
“Although the pace of economic growth remains frustratingly slow, the character of the U.S. recovery has broadened significantly in the last year as it is now firing on more cylinders than ever. Average monthly household job gains have been stronger than at any time in the recovery, the U.S. labor force has finally been growing steadily, the unemployment rate has declined by its largest amount and by its most sustained pace in the last 14 months, the household debt service burden is back near all-time record lows, household net worth has almost fully recovered from the 2008 recession, consumer confidence recently rose to a 4-year high, housing activity and home prices have finally been steadily improving, weekly bank loans have increased persistently in the last year, total state tax collections have reached new all-time highs, and the stock market is near its highest level of the recovery. As we enter 2013, the U.S. recovery has broadened considerably, become much more sustainable, and consequently much less vulnerable to external shocks. While economic fears have persistently dampened economic growth, rising confidence in the sustainability of this recovery should help boost the ‘pace’ of economic growth next year.”
—Wells Capital Management’s Jim Paulsen, “2013 Investment Outlook,” December 27, 2012