The Bond Mine Field
How you can help your clients avoid it.
December 19, 2011
The woes of the global economy have created waves of uncertainty.
For CPAs, it might be how tax laws are going to change given deficits plaguing federal and state governments. In an investment adviser’s world, it’s the great uncertainty of the global stock and bond markets. While many believe interest rates are going to remain low for quite some time, there are also those who believe that around this time next year, rates could easily be going through the roof.
While no one can accurately predict what our greatly uncertain future holds, the best thing your clients can do at this moment is educate themselves on what to do depending on how things start to shake out.
One area that deserves a few quick tips is the effect interest rates have on a portfolio of bonds. Since a vast majority of people are knowingly or unknowingly investing in them via 401(k)s, individual retirement accounts (IRAs) or brokerage accounts, knowing a something about the effect rising rates can have on this popular investment can really help your clients navigate what can easily become some truly treacherous economic waters.
With this in mind, spending a few minutes reading this article can make the difference between maintaining a calm and peaceful investment portfolio vs. a portfolio that can possibly wreak havoc on one’s financial life.
Many people consider bonds to be a very safe investment and a component that can add stability to their investment vehicles. To some extent that’s true. But it’s not quite that simple.
Bonds have typically been used to compensate for the low return on other interest-rate-sensitive investments, such as certificates of deposit (CDs). However, if your client invests in certain types of bonds with long maturities when interest rates are low, they could also be locking in a low rate of return. As soon as interest rates start moving up, the value of those bonds will likely fall, making them a poor long-term investment. A key to evaluating how much a bond’s value could fall is the length of time that the bonds will be held, which takes into account their maturity and duration.
Rise and Fall of Bonds
Generally, rising interest rates drive bond prices down. If your client buys a newly issued $10,000 bond when interest rates are at eight percent, the bond will yield eight percent or $800 annually. But if after the purchase the prevailing interest rate increases to nine percent, a newly purchased $10,000 bond would yield $900 annually. If your client wanted to sell that bond, who would pay $10,000 to get $800 in interest when the going rate is $900? To offset this, your client would have to reduce the price on their bond, making it less valuable than a newly issued bond.
Generally bonds shouldn’t be sold when interest rates rise. Bonds are an important part of most portfolios. Instead, your client should pay attention to their bonds’ maturities to better manage their sensitivity to interest rate changes.
Should rates rise and bond values fall, your client shouldn’t want to be “locked in” to a bond that doesn’t mature for years. But if your client purchases shorter-term maturing bonds, they will be able to replace lower-value bonds as they mature. Your client can do this by purchasing individual bonds or, typically, investing into a mutual fund that invests in bonds, which picks bonds for their investors.
If using high credit quality bonds, your clients should stick with individual bond purchases given that a bond fund lacks a maturity date. If interest rates rise, the value of a fund will typically drop, with investors having no idea when their principal will equal the amount invested. Conversely, when your client invests in an individual bond, as long as the issuing company does not default when the value of the bond drops, then they can typically hold until maturity, when their principal is returned.
That said, many people still invest in bond funds and for that reason.
Average duration is perhaps the best reflection of a fund’s sensitivity to interest rate changes because it indicates the percentage change in the value of a bond fund for each one-percent change in interest rates.
Example 1: Bonds in Fund A have an average duration of three years. That means, for each one-percent change in interest rates, the bond fund’s price should move three percent (one percent times three years) in the opposite direction of the rate change. So, in this example, when interest rates rise one percent, this fund’s price should fall three percent.
Example 2: Suppose bonds in Fund B have an average duration of 10 years. For each one-percent change in interest rates, this bond fund’s price should move 10 percent — again, in the opposite direction of the interest rate change. When interest rates rise one percent, this fund’s price should fall 10 percent.
As the examples illustrate, the lower the average duration of the bonds held in a fund, the less the bond fund’s price should fall when interest rates rise. These calculations can get complicated, but most portfolio managers will do the work for your client by classifying their bond funds according to average duration:
If your client stays in bonds and wants to avoid the greatest possibility of loss, to offset interest rate risk, be sure they generally stay in funds that are classified as short term.
Alan Haft is an investment advisor, author of three books including the national bestseller, You Can Never Be Too Rich and makes frequent appearances in national print, television and radio media such as The Wall Street Journal, Money magazine, CNBC, BusinessWeek and many others. The amounts represented in this article should all be considered hypothetical, for example only and the facts should always be checked with a qualified tax professional before any actions are ever taken.
For full disclosure, Haft is a part of a firm that utilizes all industries which typically includes us receiving percentage based fees for brokerage services as well as commissions when implementing insurance based plans. Haft does not work for any particular financial company or industry nor should this column be construed as an endorsement or condemnation for any particular product. Readers should note that all views and vendor recommendations as expressed in this article are solely the author’s and do not necessarily reflect the views of the AICPA CPA Insider™ or the AICPA.
* This article is not intended to provide financial planning, tax or legal advice and should not be relied upon as such. Any specific tax or legal questions concerning the matters described in this article should be discussed with your tax or legal advisor.
** The AICPA’s PFP Section provides information, tools, advocacy and guidance to CPAs who specialize in providing tax, retirement, estate, risk management and investment advice to individuals and their closely held entities. All members of the AICPA are eligible to join the PFP section. For CPAs who want to demonstrate their expertise in this subject matter, apply to become a PFS Credential holder. For more topics such as this, join us at the 2012 Advanced PFP Conference on January 16-18, 2012 in Las Vegas.