Yahoo Finanzen 4 Facts Investors Should Know About Bonds
If you listen to investment pundits, or read them with any frequency, you'll hear a consistent mantra: Bonds, particularly treasuries, are a losing proposition, at least in the current investment environment. Unfortunately, the analysis behind such a view isn't a valid reason for you to avoid them in your portfolio. That's whether or not you believe interest rates will fall or rise.
"Bonds provide much more protection than most people realize," says Peter Tchir, managing director of macro income strategy at Brean Capital in Darien, Connecticut.
First let's deal with the general logic of how bonds work. Bond prices and yields move in opposite directions. Put another way, when interest rates rise, then the bonds lose value. That's always been true. The more rates rise, the bigger the drop in bond prices.
Many of those analysts who are bearish on bonds see that the 10-year Treasury now yields a mere 2.3 percent and point to the fact that such a rate is historically low. Ten years ago, such bonds yielded 4.4 percent, which was even lower than the yield a decade before that. So the idea is that as rates move up to more normal levels, bond investors will take a bath.
The first flaw is that bond investors only incur a loss if they actually sell the security. If you buy a 10-year Treasury you will get interest payments from now until it matures in a decade, at which point you'll get the principal back. There would be zero cash losses in this case.
The yield curve is steep. But there are other things going on as well. Tchir says reinvested interest income is only part of the story and points to the so-called yield curve. "It is typically steep," he says.
What this means is that a 10-year bond will have a higher interest rate than a seven-year bond, which in turn will have a higher rate than a five-year bond.
As you hold on to your 10-year bond, it doesn't stay a 10-year for long. In three years, it's a seven-year bond. But that seven-year bond has a lower yield and so it has a higher price (that's on top of the interest.) This phenomenon continues to happen all the way to the maturity of the bond.
"You get paid to wait," Tchir says. It's known as surfing down the yield curve.
Currently, the 10-year Treasury yields 2.3 percent, versus 1.7 percent for a five-year security. That difference in yield of 0.6 percentage points means that even if the cost of borrowing by the government goes up by that much (0.6 percentage points) you will not have lost money on the bond and you'll still have the interest income, Tchir says.
Bonds offer diversification. You also get huge benefits of diversification of holding bonds. "One notable thing about Treasury long bonds is that they are the No. 1 diversifier of equities," says Anthony Valeri, a fixed-income strategist for Boston-based LPL Financial.
That means that adding some treasures to your portfolio will mean less overall volatility in total value because when stocks go down in value government securities tend to rally.
Valeri suggests allocating up to 10 percent of a fixed income portion of a portfolio to high-quality long-dated bonds, such at the 10-year treasury. For someone, with a 30 percent fixed income allocation, that means 3 percent in T-Bonds.
Deflation could push rates down. The reasons for owning bonds currently doesn't depend on rates moving lower or higher. But there are those who believe that rates will actually head south once again, which is another reason to own bonds.
"Rates will go lower because of deflationary pressure within the economy," says Lance Roberts, chief portfolio strategist Clarity Financial in Houston.
Interest rates are partly a function of inflation expectations, but also depend on how fast investors think the economy will grow. Roberts sees neither high growth nor burgeoning cost pressures pushing the cost of borrowing higher.
In fact, the deflationary pressure, or the push down on prices of goods and services as well as wages, may overwhelm and push interest rates even further lower. The stronger dollar is great for consumers, but it also means inflation is being kept down as well.
On the other side of the situation, he says that with the U.S. economy growing relatively slowly (at least by historical standards) there is little room for the cost of borrowing to increase before it starts to weigh heavily on the housing market and then the broader economy.
The public can be bad at forecasting. There's another reason to believe that rates might go down. That's because the public seems to think they will go higher. It's known as a contrarian indicator and the general public is unusually bad at forecasting investment trends.
When sentiment reaches "extreme levels" it is a good contrarian indicator, says J. C. Parets, founder and president of Eagle Bay Capital, a New York-based asset management company. He thinks we are seeing such an extreme with a thunderous noise from financial media about rates headed higher.
There are many mutual funds specializing in long-term bonds, such as the Vanguard Long-Term Bond index (VBLTX), which concentrates on treasury securities; it has low annual expenses of 0.2 percent, or $20 per $10,000 invested. Another option is the GuideStone Extended-Duration Bond (GEDZX), which owns corporate bonds in addition to Treasurys, and has annual expenses of 0.75 percent.
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