Ask Terry Questions Bonds — risks vs rewards?

Bonds — risks vs rewards?

By Terry Savage on October 21, 2013 | Investments

Hi Terry, I have much respect in your expertise and I would like your thoughts about investing in bonds. I am retired and have 40-45% of my portfolio in Vanguard bond funds. I have focused on short and intermediate term bonds (avoiding long term funds) and as you know all bond funds have declined in value the past few months. Some financial planners advise avoiding all but very short term bonds. My question is this: if I’m already invested in a midterm bond fund paying a decent (3-5%) return, why would I want to sell the fund at a loss just to reduce my exposure to a reduction in value if…and this is key….if I have no need to sell the bond fund for other reasons? What’s the problem with holding the bond fund and collecting the interest rather than selling the fund now at a loss? It seems foolish to sell it just so I can get into shorter term bonds that, even though they have shorter duration and therefore have less exposure to interest rate fluctuations, also pay less interest. Does my question make sense? Where’s the flaw in my logic? Thank you very much for your common sense and newsletters. I trust your advice more than any other high-profile financial experts.

SAVAGE SAYS:This is the $17 trillion dollar question!  First the basics:  When interest rates rise, bond prices fall.  That’s because no one will give you $1,000 for your 20-year 3 percent bond, if rates rise.  At that point, someone holding cash might be able to buy a 5% -20-year bond.  So the price of your existing fixed-rate bond will fall to about $800, a point which will equalize the “yield to maturity” for the buyer — that is, make him or her whole for holding a low rate bond, a good deal because the buyer paid less than face value and will get the difference when the bond matures.  Get it?

That rule applies to all bonds, of good quality (US govt debt) and questionable quality.  When rates rise, bond prices fall.  (Of course with a junk bond you have other risks, such as default, so you get a higher interest rate on the bond to compensate for the risk.)

The amount of the price decline when rates rise is mostly determined by the maturity of the bond — the length of time until the face value will be repaid to y ou but the issuer.  Asyou might expect, longer maturity bonds face a larger price decline when rates rise than shorter maturity bonds that will get paid off in full in just a few years.

One more key issue:  What would make interest rates rise?  Well, inflation (money printing) could make rates rise, if people fear for the future buyiing power of the currency and demand higher rates to lend money.  (That is the ultimate peril of the growing U.S. national debt.)  One people fear holding all that money already printed, and all the future money printing that is expected, rates could soar.

Now, to answer your question.  If you own one bond, or a FIXED portfolio of bonds, with a maturity of 3-5 years, you won’t lose much.  When the bonds are paid off in a few years, you can reinvest at higher rates.  BUT if you own a managed bond fund, here the portfolio managers keep buying more bonds as current ones mature,  then you have to sell the fund to get your money out.  And depending on inflation, you will take a loss of principal.  That could be a huge loss if you are in a longer-term bond fund.

So that is your tradeoff between “chicken money” (money in teh bank paying next to nothing, but your principal is guaranteed safe) and taking a bit of risk owning bonds that are high-quality, medium term, and paying a bit more.

What do I do myself?  I have lots of chicken money, and yes, I do have an intermediate term Treasury bond fund for a bit more yield.  I have been tempted to sell, but haven’t done that so far!  As the economy stalls, it appears that rates will stay low — until that moment when there is a stampede out of the dollar because inflation fears re-emerge.  wish I could tell you if and when that will occur!



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