With so many investors piling into bonds and bond funds I thought it would be a good idea to comment on the risks this might entail going forward. Investors in longer-term Treasuries could be in for a rocky road ahead. We have seen an epic “flight to safety” the last few months. In April alone, $20.6 billion moved into bond funds, according to Lipper. In the same month, $12.7 billion left stock funds (which marked the 12th consecutive month of net withdrawals).1
The price of debt has really gone up, particularly U.S. and German sovereign debt. On June 1, the 10-year Treasury yield settled at 1.47% after touching an all-time low of 1.44%. It has consistently been below 2% since April 26. Germany’s 10-year notes were yielding around 1.2% during early June.1,2,3 What do these historically low rates mean for bond returns going forward? In the short term, few expect the current bond market climate to change. The question is what happens when it does and rates start to go back up?
Are bond investors going to pay for it? At some point, interest rates will rise again and when rates go up bond prices go down. When that happens, how many bond owners are going to hang on to their 10-year or 30-year Treasuries until maturity? Who will want a 1.5% or 2.5% return for a decade? If you have to sell a bond before its maturity you get the market value. Bond funds are priced everyday so they will reflect the lower value of the bonds in the funds’ share price right away. If the federal funds rate rises 3%, a longer-term Treasury might lose as much as a third of its market value as a consequence! It wasn’t that long ago – June 12, 2007, to be exact – when the yield on the 10-year note settled up at 5.26%.2
What if you want or need to stay in bonds? In my opinion, avoid U.S. Treasures. There is still good value and much higher yields in municipal, high yield corporate, floating rate and certain international and emerging market bonds. Moving into shorter duration bonds can also help protect bond values if rates go up. Be sure to explore how exposed your international bond funds are to EU nations in trouble. According to Morningstar data from early June, global bond funds have an average exposure of 2.1% to Spanish, Greek, Italian and Irish bonds. There are exceptions: in early June, some bond funds had anywhere from 7-11% exposure, believing that the high yields of these bonds are still worth the risk.1
Appetite for risk may displace anxiety faster than we think. Why would people put their money into an investment offering a 1.5% return for 10 years? In a word, fear. The fear of volatility and a global downturn is so prevalent that many investors are playing “not to lose” and are piling into “safe” bonds. However, should interest rates rise sooner than the conventional wisdom suggests, owners of long-term bonds might find that these “low risk” bonds have more risk than they imagined.
- www.reuters.com/article/us-europe-bonds, 6-4-12
- www.treasury.gov/resource-center/data-chart-center/interest-rates, 6-6-12
Damien helps individuals invest and manage risk. He is a Certified Financial Planner™ professional and a principal of Walnut Creek Wealth Management. These are the views of Damien Couture, CFP®. Investing in mutual funds is subject to risk and loss of principal. There is no assurance or certainty that any investment strategy will be successful in meeting its objectives. Investors should consider the investment objectives, risks and charges and expenses of the fund carefully before investing. The prospectus contains this and other information about the funds. Contact Damien Couture at Damien@walnutcreekwealth.com or (925)280-1800 x 101 to obtain a prospectus which should be read carefully before investing or sending money. Your comments are welcome.