No matter what is happening — or expected to happen — in the bond market, people are always asking me what they should do about bonds. Should they sell? Should they buy? Should they wait?
I'm going to give you the right answer, but it won't make much sense unless I give you some background first.
Right now, interest rates are near their historic lows. That means a couple of things. It means that, at least in theory, bond prices are relatively high. And it means bonds aren't paying much interest. (In many cases, the safest bonds are paying next to nothing.)
In addition, interest rates are expected to rise in the future. (This has been true for at least the past 10 years, so don't hold your breath.) When that happens, bond prices will almost certainly decline.
You probably already knew that. Does this mean bonds are a raw deal? Does it mean retirees and other investors should sell? If the answer is no, then why does it make sense to own bonds or buy bonds?
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To figure this out, a good place to start is making sure you understand the fundamental relationship between bond prices and interest rates. (This is also something you probably know, but let's review it anyway.)
If you were to take a class for would-be financial planners, you might learn it this way: The instructor stands in front of the classroom (I know this sounds horribly old-fashioned these days, but some people still teach and learn in actual classrooms) holding up a pencil in the middle between her thumb and forefinger.
Imagine the pencil as a teeter-totter, she will say. She'll twist her fingers to show that when one end of the pencil goes up, the other inevitably goes down. That's the whole demonstration — in fact, it's almost the whole lesson if all you need to know are the basics.
Think of the sharp end of the pencil as interest rates and the eraser end as bond prices. If you increase either one, the other drops. When interest rates rise, bond prices drop. When interest rates fall, bond prices rise.
To understand why that is true, think of a simple example, perhaps exaggerated a bit. Imagine you own a bond paying 3% interest. If you wanted to, you could sell it (we'll imagine) for its face value of $1,000. Now imagine that within one week, interest rates rise sharply, and investors can buy a new bond of equal quality that pays 3.5%.
That 3% bond you own is exactly the same as it was before. Nothing about it has changed. But an investor who was willing to pay $1,000 for your bond last week now can get a "better" one (paying higher interest) for the same $1,000. He might still buy yours, but he'll offer you less money, since he expects a yield of 3.5%. Result: the value of your bond in the secondary market has dropped.
The same phenomenon can occur in the other direction. If interest rates suddenly drop to 2.5%, that 3% bond you own starts to look more attractive, and you can sell it for more than the face value.
Back to the original question: What should you do? Investors have a hard time with this because they aren't clear about why they own bonds in the first place.
As far as I can tell, there are only three sensible reasons to own bonds:
First, the traditional reason is to collect interest. When you buy a bond, in effect you loan money to a company or government entity in return for a promise to pay a given rate of interest for a fixed period. At the end of that time, you'll get your money back.
Second, the reason that I advocate owning bonds (bond funds, actually), is to reduce the risks of owning a portfolio of stock funds. Bond prices are less volatile than stock prices, and often their prices trend in opposite directions.
Third, you can own bonds because you want to make a profit by buying them at low prices and selling them when their prices are higher. This is a perfectly sensible reason to own any investment.
Let's look at these rationales one at a time to see what they tell us about what you should do when prices or expectations change:
One: If what you want from bonds is to collect interest, and if the interest you are receiving is sufficient for your needs, then you probably shouldn't do anything. Sit tight. Bond prices in the secondary market won't affect the interest you collect. If you sell your bonds, your interest payments will stop, defeating your purpose.
Two: If what you want from bonds is to stabilize an overall portfolio, then you would also defeat your purpose by selling bonds. In this case, the bonds can do their job for you only if you own them. You want their prices to move up and down, like the ebb and flow of a tide, to provide stability. (And you'll get some income along the way as well.)
Investors who want to use bond funds to stabilize their portfolios may need to buy or sell them from time to time to fine-tune the amount of risk in their portfolios. But this is usually determined by factors other than near-term expectations for bond prices.
Three: If what you want from bonds is to make a profit by buying low and selling high, then you should sell when the prices are relatively high and buy when they are relatively low. Right now it's hard to make a case that interest rates will go much lower (which would lead to higher prices). So if your motive is capital gains, this might be a time to sell – depending of course on what you paid for them.
This all sounds pretty simple, but it isn't, for one very human reason: Many bond investors (perhaps most) want more than one result from owning bonds. In some cases, conflicting motives lead to conflicting advice.
You can own bonds for the first two motives — income and stability — although you will be able to think more clearly about bonds if you designate one or the other as your primary goal.
But if your objective is to buy and sell bonds to make a profit, you should have that as your exclusive goal. For example, if you aren't willing to give up your interest payments, you'll have a hard time selling bonds to make a profit. Likewise if the reason you own bond funds is to stabilize a retirement portfolio, you won't achieve that goal if you sell to book a profit.
Again the question: What should you do about bonds? I think the right answer for you will emerge only after you know what you want bonds to do for you.
The good news is that you actually can use bonds and bond funds to achieve all three of the things I've described: interest income, portfolio stability and capital gains.
The way to do that is to separate your holdings into three separate accounts, and manage each one accordingly. This could be a simple answer to a complex question.
I can't help you know when to "buy low" and "sell high." But if you are looking for income from bonds, I suggest you follow my Vanguard Monthly Income Portfolio. If you're using bonds to bring stability to a tax-deferred portfolio, you can use the fixed-income funds and exchange-traded funds in my recommended portfolios at Vanguard, Fidelity, T. Rowe Price and Charles Schwab. You'll find both of these sets of recommendations here.
Richard Buck contributed to this article.