Written by Thomas M. Geier, CPA, CFP®, PFS
One of the biggest challenges for bond investors at the moment is how to mitigate against losses to their bond holdings caused by rising interest rates. It is widely alleged that the US Federal Reserve has artificially suppressed the market rates for yields as a result of their Quantitative Easing programs. In fact, if you take a look at the chart below, you can see that rates on 10 year US Treasury Notes (a benchmark for bonds) is near the lowest it has been over the last 60 years. The burning question on everyone’s mind is, “When will rates start rising back to normal?”
Most bond investors understand that market values of bonds change as interest rates rise and fall. For example, let’s assume you invested $1,000 in a 10 year US Treasury Note today at 2% interest. If you had an emergency and needed that money next month, as long as interest rates remained at about 2%, you probably could sell your note and get back about what you paid. However, if your emergency occurred one year from now and interest rates had risen to 3%, you will not be able to get what you paid. A buyer will not want to purchase your note paying 2%, when they could buy a newly issued note paying them more interest at 3%. Over the next 9 years, your note will pay $180 in interest, whereas a newly issued note will pay $270. Just to get a look from the buyer, you would need to discount your note from $1,000 down to $910. Bottom line, if you need to sell your note before it matures, you will lose $90 because interest rates rose.
The important factor here is “need to sell”. As long as you can hold onto your bonds until maturity, you do not need to fear the market effects of rate changes. In fact, any short term market losses (as well as gains) self-correct to face value as the bond approaches maturity. In our example, if market rates were at 3% ten years from now, even though another buyer would not pay you $1,000 for your note, the US Government will. It will return the full amount, the face value, you invested.
For many very good reasons, a majority of bond investors utilize bond mutual funds for this portion of their asset allocation. Instead of holding a few, specific bonds in an account of their own, they hold a piece of many bonds along with numerous other shareholders, inside a mutual fund. Is this dangerous on the cusp of a raising rate environment? Apparently many bond investors think so. Back in June of 2013, the Federal Reserve first announced the wind down of QE. The anticipated effect on interest rates caused a panic and mass exodus by bond investors out of bond funds.
This is unfortunate. As we saw in our example above, the reduction in the value of a bond due to an interest rate increase is only realized when the bond is sold before its maturity date. As long as the mutual fund manager is not forced to sell part or all of the bonds in the fund, any losses will self correct to face value as the bond approaches maturity. The danger is whether there are so many redemptions by shareholders that the fund manager is forced to sell, thereby booking the loss. Hypothetically, if a bond mutual fund’s net asset value drops by 5% due strictly to an increase in interest rates, the fund has an automatic 5% gain booked into the NAV yet to be realized. This is as long as the fund manager holds the bonds to maturity. The gain will be added to the NAV most likely in the time frame of the average duration of the fund’s bond portfolio.
The 2013 panic was unfortunate in that interest rates did not increase as expected. In fact, they dropped in 2014, and bonds had one of the best years in many. In addition, if the investors who sold their bond funds stayed in cash, they had to forgo the higher interest payments that the bond fund most likely paid. Also, most bond fund managers are able to manage the duration of their portfolio as bonds mature and new money is received into the fund, to purchase new bonds at higher yields and different maturities.
A smart solution for an anticipated rise in interest rates is a bond ladder. A bond ladder is a group of bonds purchased at staggered maturities over a set time period. For example, if you wanted to invest $100,000 in a very simple 10 year bond ladder, you would structure the ladder so that $10,000 worth of bonds matures every year. In year 1, the $10,000 in bonds that matured would be rolled into new bonds. If interest rates are rising, every year, some amount of your bond portfolio is maturing allowing you to buy new bonds at the higher interest rate.
Bond ladders can be constructed with a wide range of flexibility. If you needed a certain amount of money in five years to buy a car, you can vary the maturities to accomplish this. If a set level of income is the goal, the duration (average of the bond maturity dates) of the portfolio can be tweaked to get the highest yield at the most comfortable credit risk.
If you examine the chart below (courtesy of Crestmont Research), you can see that over the last 113 years, a bond ladder with a term of 10 years or less has never had a negative return. Ladders of longer terms of 15 to 20 years do show negative total returns, but less than 3%. The actual losses that other bond investors could have realized during this time frame were possibly avoided by those who utilized bond ladders.
Most importantly, bond ladders can be customized to meet individual client needs. Factors such as income and distribution needs, risk tolerance, age, tax planning, and market outlooks can be considered. All of the pros and cons can be weighed and balanced.
At Geier Asset Mangement, we can help you determine the best solution for the bond portion of your asset allocation. We do not know when actual market rates will return to their normalized levels, but we can work to maximize the opportunity and minimize the downside.
© Geier Asset Management, Inc. March 2015. Thomas M. Geier is a Vice President of Geier Asset Management, Inc., a Registered Investment Advisor. The above blog reflects the opinions of Mr. Geier and not necessarily the firm. Any advice given is general in nature and investors must consider their own individual circumstances. Past performance is no indicator of future performance. The firm makes no warranties or representations of any kind relating to the accuracy or timeliness of the information provided.