Will interest rates actually continue to rise? Rates have moved steadily upward since this past summer's historic lows, but they could linger at current levels for some time.
Bonds react differently to rate changes: There are about a dozen bond varieties, all of which react to rising interest rates in unique ways.
Bond stability: Bonds can provide significant price stability when compared to stocks.
I want to address each of these issues, but let’s start with a primer on bonds. Bonds are simply interest-paying IOUs issued by a company or government. When you buy a five-year bond for $10,000, the seller is using the $10,000 for that specific term, while at the same time paying you annual interest. At the end of the term, aka the bond’s maturity, you get your $10,000 back. Over the whole term, you’ve collected $500/year (5 percent on $10,000) in interest. Assuming, of course, that the issuer doesn’t default on the bond.
Bond default rates vary widely depending on the type of bond. U.S. government bonds are the gold standard of credit. Corporate bonds also generally have a low probability of default, with the average default rate of less than 1/2 of 1 percent over the past 50 years. High-yield or junk bonds are, well, riskier. They have an average 20-year default rate of 3.9 percent.
Will rates actually continue to rise?
At the start of 2014, economists widely believed rates would increase over that year. In reality, rates fell. Such wrongheaded predictions have been common since 2010. I’m not suggesting rates won’t go up from here (10-year U.S. government bonds are yielding roughly 2.5 percent), but predicting interest rates and the fate of the bond market has proved over time to be just as fruitless as predicting the exact peaks and vales of the stock market.
Not all bonds are created equal
A 1 percent rise in interest rates will have very different effects on different bond categories. For instance, very long-term bond prices (30-year U.S. Treasuries) will typically fall 18 percent when interest rates rise 1 percent, while floating rate bond prices normally stay virtually flat during a 1 percent interest rate rise.
Boring ol’ bonds offer a price stability that few other asset classes can provide. A bad month for stocks might mean a 17 percent tumble. A horrific month for bonds could result in a 2.4 percent dip, as we saw in November 2016, the worst month for bonds in 12 years. The right categories of bonds can help dampen wild portfolio swings, regardless of the interest rate environment. Reducing those swings is important, given that knee-jerk, emotional decisions — usually spurred by market dips — are a leading cause of lost portfolio value.
Think about this: Going back to 1950, the best year for the S&P 500 was a positive 47 percent, while its worst year’s performance was a negative 39 percent. A portfolio made up of 50 percent stocks and 50 percent bonds registered a 33 percent gain in its best year, but its worst year was down only 15 percent.
But the main reason we own bonds is for the interest income they generate. Currently, government bonds yield between 1/2 percent and 3 percent, while corporate bonds pay between 2 percent and 4 percent, and high-yield bonds offer 4 to 6 percent per annum. This may not sound like a lot, but over a decade, those small percentages can add up to significant returns.
So, with interest rates rising, do bonds still have a role to play in your portfolio? For retirees who like stability and a generally consistent return, the answer is likely yes. Bonds might not get the spotlight too often, but just as Batman needs Robin to help protect Gotham City, your stocks need bonds to help protect your portfolio.
Wes Moss has been the host of “Money Matters” on News 95.5 and AM 750 WSB in Atlanta for more than seven years now, and he does a live show from 9-11 a.m. Sundays. He is the chief investment strategist for Atlanta-based Capital Investment Advisors. For more information, go to wesmoss.com.
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