In my last article two weeks ago, I referenced the lack of interest of a majority of individual investors to invest in stocks. In fact, they have been net sellers of equity investments pretty much since the end of the financial crisis in 2009. That comment then begs the question – Where are investors putting their money?
It is obvious that investor’s favorite investment in the last few years, other than holding very large amounts of money in cash equivalents like money market funds and certificates of deposit, have been buying bonds of all types. Perhaps attracted by the promise of regular income payments from bonds and bond mutual funds and volatility that is usually significantly less than stocks, bonds have gained in popularity in today’s less-certain economic and political climate.
Since many investors also love to buy investment vehicles based on a “what have you done for me lately” analysis, the great performance of most government and corporate bonds since the financial crisis bolsters investors’ confidence that these great returns can continue. But, it’s not quite that easy. History reveals an unkind pattern for those who rush headlong into a trend, blindly assuming it will continue unabated. I don’t believe there is reason for panic in the bond world just yet, but at some point, things will change.
It is important to segment the bond market into sectors, just like we commonly do with the stock market. First, are government bonds. Now we cannot paint every government bond with the same brush, but in general, government bonds are perceived to be the higher quality segment of the fixed income securities market because a government which prints money can always pay off its debt. I’m not saying aggressive debasement of a currency to pay off bonds previously issued is a good idea, but at least you can generally count on getting the principal value of your bonds back at maturity.
The risk in government bonds therefore isn’t so much return of principal, but more a case of return on principal. At today’s very low rates, a 10 year U.S. treasury bond is yielding about 1.8 percent. If rates were to rise even moderately during the bond's lifetime, the principal value could temporarily drop, perhaps to a level well below face value. As long as you don’t need to sell, the bond will still mature at full face value, but life has a way of sometimes causing us to have to sell investments to create spendable dollars, and it may be at an inopportune time when bond values are down.
Advisors like myself are fearful that the general investing public does not have a grasp on this risk factor since we’ve haven’t seen a rising rate environment of any seriousness since the early 1990s.
The other side of the bond market is high yield bonds. These bonds carry less certainty of return of principal because they are issued by lower credit quality corporations and governments. The reason to own these higher risk bonds is the much higher yield they pay to compensate for the increased risk.
Investors have fallen in love with high yield bonds recently and 10s of billions have flowed into high yield bonds funds in recent months. The risk in these bonds, in addition to the lower credit quality, is the sensitivity of their price to the economic cycle. In this respect they are very similar to stocks, and while less volatile than stock prices, they can still undergo significant prices swings that may surprise the unwary investor who was just focused on the attractive yield.
So, just as with any investment, bonds and bond funds carry risks that will eventually become apparent. Make sure you have a grasp on the potential risk if unforeseen events transpire and a plan for when trends begin to change.
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing. Visit www.breitercapital.com.