The stock market regularly makes headlines, especially with the wild swings we’ve experienced lately. But volatility among stocks is nothing new. What investors should really pay attention to, experts warn, is the bond market.
Long considered a secure, steady way to earn income and hedge retirement savings against risk, bonds likely won’t be such a haven for much longer. “The volatility that we may experience in the bond market could easily exceed the volatility that’s normally associated with the stock market,” said Ric Edelman, a financial advisor, author, syndicated radio host and co-founder of Edelman Financial Engines. “And the worst part is, it will hit the very investor who’s least able to sustain the volatility: the conservative, income-oriented investor who is retired and doesn’t have 30 years to wait for recovery.”
“Investors that went into bonds under the guise of safety could get a rude awakening if interest rates rise.”
Interest Rate Risk And Its Effect On Bonds
Rather than focusing on the short-term fluctuations of the stock market, which don’t have much bearing on long-term goals, such as saving for retirement, Edelman said investors should be more concerned about interest rates and their effect on the bond market.
“Nobody expected that interest rates would stay so low for so long or that we might experience zero or even negative interest rates,” Edelman said. “That means investors need to recognize the notion of interest rate risk.”
The 1970s are considered by many to be one of the worst economic periods in modern American history. “Folks who are old enough to remember can fondly recall the days of 15% CD rates and can also lament the days of 21% mortgages,” Edelman said. Interest rates were at all-time highs until Ronald Reagan took office in 1982, at which point interest rates began to come down (you can argue the degree to which Reagan was responsible for this).
Considering that the average investor is in the market for about 40 years, according to Edelman, most investors today have only ever experienced consistently falling interest rates with a few upward fluctuations here and there. It also means they’ve only ever experienced a rising bond market, since interest rates and bond yields have an inverse relationship.
“It has caused many investors to conclude that this is the way bonds always behave because, in their individual memory, that’s the way bonds always did behave,” Edelman said.
What people may not realize is that at some point interest rates will have to rise again, which means bond yields will fall in value. “They are on opposite ends of a seesaw: When one goes up, the other goes down,” Edelman said.
Today, that ratio is about 1-to-7, meaning for every 1% change in interest rates, there’s a 7% change in bond values. “If interest rates go from 2% to 4% ― a 2% increase ― bonds could lose 15% of their value... and the majority of bond investors, I fear, are not aware of this risk,” he said.
Is It Time To Ditch Bonds?
Greg McBride, a chartered financial analyst and senior vice president at Bankrate.com, agreed with Edelman’s sentiment. “There is a ton of risk in the bond market, concentrated among long-term bonds,” he said. “And a lot of investors that went into bonds under the guise of safety could get a rude awakening if interest rates rise and the value of those long-term bonds plunges.”
Of course, experts have been claiming for the last 10 years that rates are going to go up. When they have risen, they’ve done so modestly, only to move right back down. “A skeptical investor might think this is crying wolf,” McBride said. “But just because it hasn’t happened yet doesn’t mean it’s not going to happen.”
The whole idea of going into bonds for less volatile returns and predictable income is no longer a guarantee. “You are getting very little in the way of income, and you’ve got a risk of significant downside volatility at this point,” McBride said. “Investors would be prudent to take a little money off the table now and lighten up on bonds.”
That doesn’t mean you should ditch them entirely, however. Edelman advised that investors simply shorten the maturity. “We are recommending that you hold short-term and intermediate-term ― five- to seven-year maturities for the most part ― rather than predominantly 20- and 30-year maturities,” he said. “This will insulate you to a great degree against the risk that interest rates might rise.” Edelman pointed out that since interest rates are now very low across the board, the difference in yield between a seven-year Treasury and a 20-year Treasury is not all that significant. “So you’re not sacrificing much income in order to obtain a higher degree of safety.”
McBride added that for investors who still have a long time horizon before retirement, quality dividend-paying stocks are a much more attractive option. “The valuations are reasonable, the income stream is poised to grow over time (unlike a bond, which stays static) and you’re earning yields that are above what you’re going to get on bonds,” he said.
McBride recognized that this understandably might seem counterintuitive to investors. “The reality of it is you can generate income ― and should generate income ― across your portfolio,” he said. “Not just in bonds and fixed-income, but from equities, real estate investment trusts, master limited partnerships... some of those investments that are riskier in the short-term are a much better hedge against inflation and preserving your buying power in the long-term.”
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