There never seems to be a shortage of investment professionals willing to remind you how much money you will lose if bond yields rise. When combining the constant chorus of professionals telling everyday investors to sell bonds and buy stocks with the recent unrealized mark-to-market changes in your bond portfolio, you may be feeling a bit unsettled. Extreme volatility in financial markets has the tendency to cause people to second guess prior decisions they’ve made. For those individual bond investors feeling a bit uneasy due to the recent unrealized mark-to-market declines in their bond portfolios, consider asking yourself the following questions:
- 1. Has the issuer of any of your bonds defaulted on its debt obligations?
- 2. Is the issuer of any of your bonds in danger of defaulting on its debt obligations in the foreseeable future?
- 3. Will the bonds that are causing you uneasiness mature at par?
- 4. In the foreseeable future, do you anticipate being forced to sell any of your bonds in order to raise cash?
I have a hunch there are lots of individual bond investors who would answer those questions in this way: (1) No, (2) No, (3) Yes, (4) No. If that includes you, I hope it provides some perspective on what the recent move in bond prices actually means for you. Concerning stocks, I’ve often heard investors say that you don’t have a loss until you sell. When it comes to stocks, while that is literally true (from a tax perspective), the fact is one could conceivably carry an unrealized loss forever. But when it comes to individual bonds, which will mature at par, not only do you not have a capital loss unless you decide to sell for a capital loss, but you also will not be stuck with an unrealized loss forever. Regarding individual bonds, I can say with confidence that as long as the bond is not defaulted on, its price will recover to par. If you suddenly find yourself with bonds trading at 80 cents-on-the-dollar that you purchased at 90 cents-on-the-dollar, remember that the unrealized losses, assuming no future default, are only temporary.
Additionally, after the notable move higher in bond yields, there are a whole host of companies you may find attractive from a credit risk perspective with intermediate- to long-term debt yielding over 5% (some well over 5%). Given that the recent rise in rates has more to do with anticipated Fed policy than it does with expectations for strong future economic growth or notably higher inflation, I think the move higher in rates has made many bonds extremely attractive. In fact, bond yields even recently reached the point at which I found myself tapping into cash I anticipated allocating to common stocks in order to enter new bond positions. I can’t remember the last time I felt a sense of urgency to purchase bonds relative to stocks.
Although the federal funds rate is still at the zero bound and is likely to remain there for some time to come, bond traders have elected several times over the past few years to push yields to levels that not only fully prices in the end of QE but also prices in a portion of a Fed rate-hike cycle. The peak yields we saw in August were just the latest example. Yes, rates can head higher from here whenever the next rate-hike cycle begins. But unless the Fed intends to send the U.S. economy into recession, it won’t be hiking rates any time soon. Additionally, yes there could be complete chaos in the bond market if Washington fails to raise the debt ceiling in the coming months. But if you think you could escape that carnage by buying stocks, I think you will end up quite disappointed.
In closing, the next time you find yourself feeling uneasy about the mark-to-market changes in your bond portfolio, remember to ask yourself the four questions mentioned above. And, as hard as it may be to add to an asset class that has had a few months of terrible price performance (like bonds), when you have the luxury of holding to maturity, it should give you more confidence that buying the dips in bonds will work out for your portfolio in the long run.
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