Be patient with bonds
Earlier this year when the investment markets were anticipating the Federal Reserve would raise interest rates, which it has done, the financial press was warning investors to get out of bonds – or at least get into the short-maturity end of the market to avoid the expected consequential losses in bond values. Some investment advisers also jumped on this bandwagon.In the upside-down world of bonds, as market interest rates go up, the interest rates on new issues of bonds rise with them. However, as a consequence, the prices (principal value) of existing bonds fall because of their lower fixed interest rates, which are, obviously, less attractive to investors when compared to the higher yields on the new bonds.In June, the Investment Company Institute reported that billions of dollars had flowed out of bond mutual funds and into safer money market accounts and some not-so-safe bank-loan and adjustable-rate mortgage funds. Today, the fundamentals of the credit markets certainly point to higher interest rates. Therefore, it’s critical that investors that choose to have some percentage of their investment portfolio in the fixed-income asset category get the story straight on bonds. Bond mechanics 101 Investors own bonds for their income, for prudent asset allocation, and for the safety of principal. As a percentage of your overall portfolio, your bond allocation will vary according to your investment objectives, risk-tolerance and age. But bonds purchased directly or indirectly through mutual funds have a place in almost every portfolio, particularly as they relate to retirement investing.You don’t need an advance degree in finance to understand that if you don’t sell your bonds or bond funds, interest rate movements and bond price fluctuations are meaningless. Any bond principal losses or gains are all on paper, or unrealized.As long as you don’t need to tap the money you have in bonds for three to four years, hold on to them and ignore the rising rate interest rate environment. All bond investors have to do is wait long enough for the benefit of higher rates to outweigh the pain of short-term, transitory falling bond values.In this regard, the Wall Street Journal’s Ian McDonald, writing back in July, hits the proverbial nail on the head with this sound observation: “Much of a bond’s return is fueled by the interest paid on re-invested income, which rises along with [market] rates. The result is that an investor’s total return is often boosted over time by the very increases that initially sap the investment’s value.” Sit tightNevertheless, bond investors need to be aware of “interest rate sensitivity.” Duration is a technical term that measures a bond’s sensitivity to interest rate movements. Duration is expressed in terms of years, e.g., bonds with intermediate-term maturities (four to six years) could have a duration in the range of 4.0 (years). The shorter a bond’s duration, the less sensitive it is to interest rate fluctuations. A good rule of thumb for investors is to choose bonds and bond funds with a duration shorter than the period they need – or expect – to hold the bonds. If you’re investing for retirement, you’re going to be holding on to your bonds and/or bond funds for the long term. As such, you’ll come out further ahead by standing pat with your bonds over any short-term “adjustment” period than by switching into shorter term, low-yielding bonds or money market funds.My advice to bond investors is to respond to rising interest rates with shouts of glee. The days of low bond yields will soon be history. Don’t be tempted to exit from rate-sensitive bonds at this time. Instead, sit tight and enjoy the rewards of better bond income. The Investing Wisely column is written by Richard Loth, managing principal of Mentor Investing, an independent registered investment adviser. Loth can be reached at 827-5591 or firstname.lastname@example.org.Vail, Colorado
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