Monday, December 5, 2016

Hurray!! The Bond Market is Crashing…

Hurray!! The Bond Market is Crashing…

Bert Whitehead, J.D., M.B.A. © 2016

The surprising election results have been followed by recent unexpected shifts in the financial markets. Stocks have soared, and bond prices have dropped substantially. Most of our clients have 15-year bond ladders in place if they are retired, or if they are still working the accumulation stages, they are building a bond ladder.

Looking at your brokerage statement now can be scary if you focus on how much bonds have dropped in value. If you have never experienced a rout in the bond market like this, don’t be unnerved. This is actually a very good development for the long-term growth of your portfolio because usually the stock market sky-rockets when bond values drop. And in fact, the stock market has been hitting market highs almost every day since the election so your total portfolio is likely increasing in value significantly if it is properly balanced between stocks and bonds.

Why does this happen? It doesn’t prove that the “right” person won or that it was caused by disfavor of the losing political party. Surprise events sometimes trigger market reaction, but the pressure for this kind of correction has been building over the past few years. Indeed we might have experienced the same market phenomenon (stocks going up and bonds dropping) if the other side won politically. What sparked the change in the market is probably the reduction in fiscal uncertainty which has been a drag on the global economy for several years. Financial markets abhor uncertainty.

The long-term favorable impact on your investment portfolio is a result of your stocks increasing significantly in value. A diversified stock portfolio is the growth machine for your finances. And your bonds, which provide safety, aren’t actually losing money.

We insist on using U.S. Stripped Treasuries in clients’ bond ladders. So the amount you have invested to buy your bonds plus all the interest earned, is government- guaranteed as a direct obligation of the U.S. Treasury if you hold the bond to maturity.

 If you became a client 15+ years or more before retiring, we have been buying some bonds for your ladder each year. This is called ‘dollar cost averaging’ and gives you the advantage of knowing your bond portfolio will end up earning interest equal to the market rate average over the past 15 years. The current increase in interest rates will be reflected in the bonds we buy for you as we are able to lock in these higher rates. So you are not gambling on interest rates and don’t have to fret whether rates go up or down.

While you have the security of knowing you will be able to maintain your current standard of living after retiring, we use the stocks to replenish the bond ladder during periods of economic growth, which pushes up the value of your stocks.

You may be wondering why your statement is showing your bonds dropping in value as interest rates rise, i.e. why bond value moves inversely to interest rates. If you buy a $10,000 bond when rates are 5%, you are guaranteed to receive $500 per year in interest until the bond matures and you get your $10,000 back.

But if you get scared (or greedy) when rates increase to 6% and want to sell your bond a year after you bought it you will realize a loss. This is because the investor who buys your bond will get only $500/year in interest whereas a newly issued bond would pay $600/year. So you have to drop the price of your bond to a “discounted value” of about $8333, so the $500/year in interest which is locked in will provide a yield of 6% to be competitive in the market.

The opposite is also true: over the past 10 years interest rates have been dropping so you may see the value of your bond increase. It doesn’t make sense to sell it however because you would pay taxes and transaction costs, and then you would have to invest at a lower rate.

So bond prices move up and down all the time, but holding your bond ladder to maturity assures you will be repaid your investment in full including interest. For long term investors who use bonds to provide their safety net and hold to maturity, the market fluctuations in value are just “noise.”

Buying and holding bond ladders provide another important benefit-- the security they provide keeps clients from panicking when the stock market crashes. The worst investment decision an investor can make is to sell low when holding a long-term investment.

The take-away from this discussion is: “Don’t let your political convictions dictate your investment strategy.” Political convictions are an exogenous issue over which you have no control, whereas with our Functional Asset Allocation model your investment returns are endogenous and tailor- made for your situation without regard to market shifts.

Thanks to Shari Cohen for copy editing.