There are a variety of reasons to include bonds in an investment portfolio. Most often bonds are utilized for the stream of income they pay out, usually on a semi-annual basis. Some investors may own bonds to diversify and smooth out the edges of a stock or real estate heavy portfolio. Others may view bonds, especially short duration, investment grade bonds, as part of their capital preservation basket or as a substitute for cash in today’s zero-yield world.
To see a list of high yielding CDs go here.
So, is investing in bonds, risky? Just like any other security with a fluctuating market value, bonds do have risk – some bonds possessing more risk than others. Risk of losing some or all of an investment (credit), market and interest rate risk prior to maturity, and opportunity cost risk are some of the general risks of owning bonds. Many pundits in today’s market say the risk is so high that investors should not own them at all. And for investors with little to no need for income, a great need for growth, or a generally hawkish (belief that rates will rise) forward view on interest rates, there may be wisdom in possessing a small or nil position in bonds.
From many angles, however, bond risk is really negligible, which is why some investors consider high quality bonds a good proxy or substitute for CDs or cash. And even when we slide down the credit quality spectrum into high-yield, default rates remain very low, meaning that capital peril for fixed-income investors even in the riskiest of bonds is currently rather benign.
So why then are bonds loathed so much and why is there so much perceived risk? Well, for one, we are in the midst of a five-year bull run in stocks where the Dow 30, S&P 500, and Nasdaq have all more than doubled. This has created an almost euphoric atmosphere compared to the rather mundane single digit returns recently found in the bond market.
While I hesitate to say that income investors are now chasing stock returns, they are certainly driving valuations above historical norms. Dividend growth, which is becoming somewhat of a catch phrase in some equity circles, is trumping investment in fixed income due to its inflation fighting characteristics as compared to lower-yielding fixed income.
Investors’ perceptions of stocks will be higher than bonds in a bull market, pure and simple. Interestingly enough, however, bonds have rallied the fist six months of 2014, which has caught many bond bears and traders off guard, as many were expecting 3.5-4% on the 10-Year Treasury by year’s end. So despite the bearish long-term animosity, there has been some near-term love from the market.
But low interest rates and cheap cost of capital, while wonderful for borrowers, is not ideal for those looking to maximize fixed return through bonds, CDs, and other obligations. This persisting low interest rate environment and fear of opportunity cost in a rising rate scenario represents another reason bonds are typically shunned by market strategists.
Thus, investors won’t embrace bonds on a wholesale level once again until either 1) coupon rates rise enough to compete for the returns that stock investors have seen over the near-term or 2) diminished returns from equities or a macroeconomic “scare” creates the common “flight to quality” (out of stocks and into bonds) that we have so often times seen in market history.
To conclude, as I’ve often times said recently, bonds don’t currently possess a compelling total return proposition. Still, I think the level of risk presumed to be inherent in bonds is often overstated, with their value either misunderstood or understated. Given some of the bold words that seem to be emanating from mouths of equity investors’ lately, I sometimes wonder if its them and not bond investors that need the primer on what constitutes risk. When a sharp equity market sell off or protracted bear market occurs, which it undoubtably will at some point, the value of a bond and asset diversity will return front and center.
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About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.
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