The general consensus is that interest rates in the United States are expected to move upwards over the next year or two. This possibility raises a concern for those individuals that have invested in longer-term bonds in the hopes of gaining a higher yield for their portfolios.
It seems, however, that not all bondholders are cognizant of the risks that such an investment presents for them. With such a forecast, these bondholders face a very serious threat of interest rate risk. But, knowledge of this risk appears absent to a lot of people.
Andrew Bolger writes in the Financial Times:
“A survey of 30,000 US adults, published this year by the Financial Industry Regulatory Authority, found that 28 percent could correctly answer the question: ‘If interest rates rise, what will typically happen to bond prices? Rise, fall, stay the same, or is there no relationship?”
One thing to remember that, in terms of experience, most investors in bonds have never really seen bond prices fall for any extended period of time. For the most part, until recently, long-term interest rates in the United States have fallen since the early 1980s.
Hence, “after decades of falling rates many small investors are unaware of the danger lurking in their bond portfolios.”
Andrew Goldberg, a strategist at JPMorgan Asset Management, is quoted as saying, “The post-crisis flight to quality has left trillions at risk, with the longer maturity and lower-yielding bonds being the most vulnerable to loss.”
The need, in this environment, is for investors…especially small investors…to become more aware of the risk that may exist in their portfolios.
It is not that these investors need to avoid bonds altogether, but to, at a minimum, know what might happen to their portfolios, and accept the reality of what they are facing.
For example, many older investors just want to earn a regular stream of income and preserve capital. They don’t want to have to deal with the volatility that might exist in a market where prices are changing, sometimes in rather dramatic ways.
These investors are probably not going to want to rotate their positions into a different configuration.
Yet, they also need to be aware that the insurance companies and pension funds that they are a part of face a very similar problem. They must not be surprised at the information that might be coming out about what these institutions are experiencing over the next few years.
It is very important, however, for these older investors to understand exactly what the situation is and what might occur because of the decision to keep their portfolios as they are.
For other investors that have longer-term bonds in their portfolios, the need is different. First of all, these investors need to make sure that they understand just how bonds work and how a rise in interest rates might impact the prices of the securities that they own. Also, they need to understand how volatile the prices of bonds of different duration might be.
Second, these investors need to determine just what it is that they are attempting to achieve with their portfolios. And, what they are attempting to achieve is tied up in the risk-return relationship they are willing to live with in their portfolios.
In all likelihood, many investors that now hold bonds will want to rotate funds out of bonds and put them into other investments, like equities.
Analysts at the HSBC bank argue that “any rise in bond yields would be likely to push investors who have piled money into bond funds in recent years back into equities.”
These analysts point to the fact that since May of this year, “investors have pulled $75 billion out of bond funds globally, compared with $787 billion of inflows since 2009.” They go on to say that “equity funds have seen $192 billion of inflows this year.”
Furthermore, with the prospects that the Federal Reserve, and other central banks, will continue to pump money into the financial markets at relatively high rates, it is highly likely that stock market prices will continue to increase in the near term.
Therefore, it is very important for investors to be aware of the environment they are living in and how this environment impacts and changes their portfolio positions. Without this awareness people will be surprised…sometimes in a negative way…and will be faced with investment portfolios that are not achieving what they would like to achieve.
You, the reader of this post, may be aware of the situation. But, are there others in your life…like ageing parents…that may not be aware. Surveys have indicated that many people that are not.
About John Mason
John has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.
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