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.
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.