Bond Investors - Please Fasten Your Seat Belts!
About the author: Trini Guillen is dedicated to helping clients achieve financial freedom. Trini holds a Series 65 securities registration and has a Bachelor of Science in business administration with a focus in finance. He has spent 21 years in the financial industry. His previous experience includes trade system research and development, portfolio management, due diligence and trade execution.
Bonds are easily the least understood asset class and most people either love them or don’t understand them at all. I would even argue that most investors that love bonds do not have a solid understanding of how to evaluate the risks associated with their bonds. In its most simple terms, as a bondholder you’re a lender and if you think of yourself in that context, you quickly get a better understanding of how you may want to select the bonds you own.
Now, I am not going to over complicate this article with specifics and nuances related to bonds and risk factors because one can quickly get deep into the weeds on this subject and bonds are, again, confusing to most as it is. So, in their most general form the four most common risks related to bonds are as follows.
Interest Rate Risk – As rates rise, bond prices fall. As rates fall, bond prices rise. The Federal Reserve has been quite vocal about their intentions to adhere to unwinding the balance sheet and moving away from the Zero Interest Rate Policy that was established during the financial crisis. As rates rise, all bonds will go down in price in a relative manner.
Inflation Risk – The yield or return on your bonds doesn’t keep up with the pace of inflation. Tax cuts and spending in the middle of a surging economy are beginning to spice up the specter of inflation as depicted in the graphic below.
Market Risk – As with any asset class, you may find yourself exposed to a period in time where the entire bond market declines regardless of the quality or type of bonds you own like a change in interest rate policy. Of course, if you hold your bond until maturity you will get a full return of your investment. However, if you’re in a liquidity event and need to sell prior to maturity you may sustain a loss. Or, the fact that bonds have risen in price for nearly 40 years have created a perception that they never go down. Many investors whom have reduced their equity risk due to their fears of equity markets have chosen the safety and calm of the bond markets.
Well, that landscape has now changed and bondholders that have not experienced a volatile bond market may soon see just how volatile bond prices can be and this can be a similar emotional event for these investors as they saw in stocks ala 2008.
Credit Risk – If you buy bonds from a company or government that is not financially stable, there is more risk that you will lose your money. Remember, you’re a lender and the quality of the borrower is imperative to the return of your money and should outweigh the return on your money when looking at bonds.
Bonds are a valuable way to diversify equity risk and to potentially smooth one’s return stream making the time that passes much more comfortable. However, bonds had a very long bull market run. Bull markets tend to build complacency and the best way to think about it is something like this.
We all have had those periods where we have not moderated our diet or exercised over a long period of time and that is very similar to a bull market, it is a period of complacency. When we finally say enough is enough and we decide to modify our diets or start an exercise program, that change is uncomfortable and at times painful. Over time we gradually see the benefits of those modifications and ultimately, we have a healthier body.
Much is the same for the markets and more specifically the bond markets. The change in interest rate policies or inflation rising will be a painful transition for bond prices and uncomfortable for bond holders. At which point there is a stabilization of rates and inflation then the calm will take over and the transition will be a healthier market.
In the end, we will need to endure the period of discomfort before another bull market takes hold. A better understanding of what you hold and what your risks are will help in providing you the resolve to weather the storm in joy and not fear.
So, as a courteous pilot will always suggest amidst entering into unstable atmosphere, I now say to you who hold bonds: We are entering into a very unstable bond environment now, so for the time being, please fasten your seat belts!