Short and Simple Guide to Bonds

Transcription

1 Short and Simple Guide to Bonds Paul Puckett

2 Introduction The purpose of The Short and Simple Guide to Bonds is to provide investors with the basic information they need to understand bonds, the purpose bonds have in their investment portfolio, and the impact interest rates have on the investment performance of bonds. This guide is not comprehensive and is intentionally short and simple. It provides the information you need to make decisions on whether to include bonds in your portfolio. Within these eight pages you can expect to find a basic definition of bonds, the historical performance of bonds, and a simple overview of what you can expect from your bond portfolio in the future. It is much harder to invest for income today For your parents, income investing was easy. In 1980, income yields on bonds and certificates of deposit were above 10%. Today, CD s are averaging less than 2% and most bond funds have yields below 3%. Producing income is challenging, but the real danger to your portfolio is still on the horizon. And that danger is in an area of your portfolio that you probably consider the safest investment you own! The biggest risk facing retired investors is the bond market! Bond prices are primarily driven by changes in interest rates. Over the past 35 years interest rates have fallen and bonds and bond funds have risen in price. During those years, investors not only received bond income but also had capital gains! For todays bond investors, the future is not as favorable. Bond and CD yields have fallen steadily for over thirty years. Investors easily found CD s and bonds with rates above 15% in the early 1980 s. Today, ten year bond rates are below 3% and five year CD s often pay less than 1%. Interest Rates are the primary driver of bond performance For most of the past 35 years, interest rates have fallen. This has provided bond investors with a high level of income and capital gains from rising bond prices. With interest rates at historical lows, todays bond investors receive very low income and the potential for capital gains is slim. As a matter of fact, significant losses will occur when interest rates rise. For income oriented investors, there are alternatives to remaining in a low income, high risk, bond fund. Let s begin with a one page overview about bonds.

3 BONDS! Definition: A bond is a loan. When you buy a bond, you are lending your money to a company, government, municipality, agency, or other organization. Source of return: Bonds pay interest and may produce capital gains or losses. Purpose in your retirement portfolio: Income Risk:! Default on interest payments or repayment of principal.! Potential losses when sold prior to maturity.! Rising interest rates cause bonds to lose value. Why invest in bonds: Income from interest payments and potential gains when sold at a higher price. Why you should not invest all of your money in bonds: Risk of loss due to higher interest rates. How to invest: Bonds can be bought individually but most investors use mutual funds and exchange traded funds to invest in bonds. There is additional risk in bond funds because investors cannot hold bonds until maturity when investing in a fund. The fund manager decides when to buy and sell each individual bond based on the objectives of the fund, not your specific objectives.

4 Bonds and Interest Rates The Past $ V a l u e Bonds and falling interest rates When interest rates fall, the value of a bond rises. The longer the term of the bond, the more the value is affected by interest rates. A two year bond will rise and fall substantially less than a ten or twenty year bond Year Treasury Note Yield 15% 11.25% 7.5% 3.75% 0% R a t e % Interest rates have steadily declined The chart above shows the yield on newly issued ten year US Treasury Notes since Rates have steadily declined and the ten year note hit an all time low of 1.42% during As a result, over most of the past 30 years, bonds have gained in value averaging a total return of 8.1%.

5 The Future? % R a t e V a l u e $ Bonds and rising interest rates When interest rates rise, the value of a bond falls. The longer the term of the bond, the more the value is affected by interest rates. A two year bond will fall substantially less than a ten or twenty year bond Year Treasury Note Yield 14% 10.5% 7% 3.5% 0% The chart above shows interest rates increasing from 1962 to A similar rate increase is overdue! There is very little reward in bonds Because bonds fall in value when interest rates rise and with historically low rates, there is very little reason to own bonds today. They offer minimal income, minimal potential gains, and high risk of loss if, and when, interest rates rise.

6 Three potential futures Interest Rates Fall Even though interest rates have fallen substantially over the past 35 years, it is still possible for rates to continue falling. It is possible for bonds to offer a negative interest rate. For example, late in 2014 Japanese bonds were among the bonds of several countries offering a negative interest rate. When this happens, investors actually pay for their ownership of bonds. Typically, bond investors receive income based on the stated interest rate of the bonds. If interest rates continue falling, owners of existing bonds will have gains. Interest Rates Remain at Current Levels If interest rates remain at current levels, bond investors will continue to receive very low income and will neither experience losses or gains on their bond portfolio. Interest Rates Rise If interest rates rise, bond investors will experience losses. The amount of loss is driven by how much interest rates increase. Bonds, and bond funds, are valued based on their duration. There are several different methods of calculating duration and all are based on the bonds maturity, interest rate, and whether the bond is callable. Callable bonds may be redeemed by the issuer prior to maturity. All duration calculations are estimates. Short term bonds generally have a duration of less than 3 years. For every one percent rise in interest rates, short term bonds will lose from 1-3%. Intermediate term bonds have maturities between 4-10 years. For every one percent rise, intermediate bonds will lose 4-10% of their value. Long term bonds have durations averaging 7-20 years and will lose 7-20% for every one percent rise in rates. Should I hold or invest more in bonds? It no longer makes sense for investors to include bonds in their portfolio. There is more risk than reward in the bond market.the income produced by bonds is lower than the potential losses if interest rates rise. Even If rates stay the same, owners of bonds will only receive historically very low interest income. If rates rise just one percent, bond holders will lose more value than the interest they are

7 receiving. Given the risks of loss combined with very low income, investors should consider other fixed income investments. The chart below shows ten of the largest US Bond funds and their performance in 2013 and In 2013, interest rates rose slightly and bond investors lost money. In 2014, interest rates fell slightly and bond investors recovered. When interest rates rise, bonds lose value. But, the long-term trend is rising rates. How much will bond fund investors lose? Duration indicates the percentage estimate of how much a bond, or bond fund, will lose for every percentage rise in interest rates. As an example, an investor in the Vanguard Total Bond Market Index fund receives annual interest of 2.23%. For every percentage increase in interest rates, the fund would lose approximately 5.63%. In terms of dollars, an investor with $100,000 in the fund would have income of $2,230 and a potential loss for each one percentage point increase in rates of $5,630. If rates rose two percent, principal losses would be approximately 11.26% or $11,260! The performance of bonds in 2013 provides an early indication of what investors should expect over the next decade, or more. Now is the time to exit the bond market.

8 A new book, Retirement IncomeLock - How to Lock In Lifetime Income provides an investment strategy for retired investors who need long-term growth and lifetime income. The book will be available on Amazon but is offered free for investors in Virginia and Florida when they meet with the author to discuss the RetirementIncome Lock strategy. For more information and to schedule a review of your current investment portfolio, please contact the author by phone at or by at paul@retirementincomelock.com. About the Author A financial services professional since 1988, Paul has extensive experience working primarily with retirees and investors who are planning for retirement. He began his career as a life insurance agent and has served as a loan officer, trust officer, registered representative, investment advisor and private client advisor with several major banks. He is an experienced estate planner who settled over 160 estates. Over the past 27 years, he has experienced the highs and lows of the markets and strongly believes investors benefit from a long-term, strategic, approach. He manages money based on the time tested technique of asset allocation based on modern portfolio theory. He believes retirement income should be safe and guaranteed, but also recognizes that all investors should maintain growth within their portfolio. For retired clients, he combines traditional equity investing with fixed annuities to help clients have guaranteed income, beat inflation, maintain their spending power, and leave a legacy to their heirs. Paul is an investment advisor representative of Q1 Advisors, independent insurance agent and Author of Retirement IncomeLock. He works with clients in Virginia and Florida and is the author of Investiphobia: Overcome Your Deepest Investment Fears. For additional information about Paul, visit and Please feel free to share this guide but please do not alter any of the guide s contents when you do. Thanks!