Don't look now, but the corner of your investment portfolio you thought was the safest might soon provide more drama than you bargained for.
Bonds, and especially bond funds, may be nearing the end of their long winning streak as interest rates begin to rise. Once that trend takes hold in earnest, many investors who believed they were pursuing a conservative course may awaken to discover they have sustained permanent losses. It's time to focus a sharp eye on those fixed income investments and be prepared to make some reallocations if necessary.
Bonds constitute an important and useful asset class for many investors. Unlike stocks with their inherent volatility, bonds generally promise a steady stream of fixed payments and return the full face value at maturity, assuming that the issuer is in adequate financial health. Some bonds, like those issued by the U.S. government, eliminate virtually all uncertainty relating to ultimate repayment thanks to their explicit guarantee. The relative predictability of fixed income securities when compared with equities makes them an important asset class for diversifying risk and for generating income.
But it is important to recognize that bonds are not without some element of risk; even so-called "risk-free" securities such as Treasury bonds still hold the potential for loss when interest rates rise. And we may finally have arrived at the threshold of a directional shift in rates.
It is hard for most investors to recall the last sustained period of rising interest rates, given that we have enjoyed a 32-year boom in the bond market. The yield on the 10-year U.S. Treasury bond declined from a peak of 15.9 percent in 1981 to an unbelievably low 1.4 percent last fall (and stands at 2.1 percent today). Since bond prices rise when rates fall, this produced lip-smacking profits for bondholders. Meanwhile, the developments of the last five years have rendered them even more attractive, given the uncertainties of the financial crisis and the increasingly challenging task of generating safe income.
Now the light is flashing yellow. Rates cannot conceivably go lower, at least for long, and the risk now is weighted toward higher yields in the months ahead. Given that most fixed income issues are presently priced at or above their face value, there seems to be little upside potential and a disproportionate probability of losses ahead.
Holding individual bonds mitigates this risk somewhat, as long as the holder is content to hang on until maturity and accept a below-market (and possibly below-inflation) return. But mutual funds and ETFs are exposed to more permanent price risk, since they do not typically hold anything to maturity and can be subject to large outflows.
This is not necessarily a reason to abandon bonds; they still play an important role in diversification and risk mitigation during periods of stock market turmoil (which are manifestly unpredictable). But now is a perfect time to review your bond fund holdings, shorten up on maturities, and contemplate the potential impact on your portfolio as rates start to climb.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Christopher A. Hopkins CFA, is a vice president at Barnett & Co. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447.
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