THE RISKS OF BONDS IN THE CURRENT MARKET
By MARY LYNNE DAHL, CFP®
December 05, 2018
A lot of these bonds have medium or long term maturity dates. That means that they will pay fixed interest at whatever rate they promise for between 8 and 30 years. Because the US has been in a long cycle of very low interest rates, the interest rate paid on these bonds has typically been only 2% to 3%.
This creates a problem for these investors. The first problem is that their bonds will not produce enough income on which to live comfortably. And, as the investor reaches age 70 ½, he or she will be required to withdraw at least 4% per year, more as the years go by, due to the IRS rule of minimum required distributions. A bond portfolio earning only 2% - 3% is not able to pay 4%, so this is a serious problem. They may have overlooked this fact when they bought their bonds, or they may have planned to sell their bonds and invest in newer, higher interest rate bonds when interest rates rose.
Selling their low interest rate bonds, however, will result in a loss of principal. Bonds are initially priced at “par”, which is $1,000, but when they sell a second time, they sell in the secondary market at various prices other than par. If the demand for bonds is high, they can sell for more than par, which is called selling at a “premium”. If the demand is low, they can sell at a “discount”, which is less than par. The problem of selling a bond and losing money on it is that when interest rates are rising, a buyer is not willing to pay par (or more) for a bond that only pays 2% or 3% interest if that buyer can buy a new bond at par which pays a higher interest rate. This is what happens when interest rates are rising, which is the case today.
For example, a 10 year bond that pays 2% interest that is sold one year after purchase, will sell at 8.1% less ( for $918.89) than par ($1,000) when interest rate rise to 4% for 10 year bonds. If rates rise to 5%, that same bond will sell for 15.4% less ( for $845.57). These numbers represent real, actual losses of principal to the investor who bought their bonds new, at par. Obviously, a bond with an even longer term until maturity will suffer greater loss if it sells prior to its maturity date during a rising interest rate cycle. This is a fact and is not something that can be negotiated between buyer and seller.
So, the problem with bonds in a rising interest rate cycle is two-fold. They don’t provide enough interest income and they will trigger a real loss of principal if sold prior to maturity, which is usually years away, sometimes many years. Some investors recognize this problem and are keeping whatever bonds they own very short term, such as less than 3-5 years. These bonds pay the lowest interest rates, so the investors don’t get much for their efforts. However, the shorter term the maturity of a bond, the less it is impacted by a rise in interest rates, but if you go medium or longer term with maturities, you are taking a very big risk, called interest rate risk, and it can cause you to lose a substantial amount of money.
The solution to this problem is complicated. Stocks that pay dividends of 3% or more should be considered if they are solid, financially strong and not very volatile. However, in a volatile market cycle like today, many investors have trouble seeing through the noise and hype to even consider stocks of any kind of quality. However, they are available and it is worth taking a look at them.
There are also certificates of deposit, which cannot be sold (generally) and are available in short term maturities. Some of these pay higher interest rates than bonds and are worth considering as well.
Real estate in its many forms also offers income to investors, but real estate can be very complicated. Some real estate is simply too risky for investors to consider, so it is usually necessary to get professional advice when looking at it as a way to receive income. Good quality real estate funds are available, however, and can be a significant source of income to an investor looking for income.
There are also insurance annuities available, but most of these are likewise very complicated and heavy with fees and policy expenses, so in order to find an annuity that not only pays a decent interest rate, it is necessary to get expert advice from someone other than the agent selling the annuity before you can determine if the fees and expense charges are worth it. Recently, we have seen the beginning of a trend of no-fee fixed rate annuities, but this is a new trend that we are watching closely to see how it turns out and consider it too new to recommend at this point in time.
Some bond traders advise a complicated strategy of hedging, using high yield junk bonds, foreign bonds and alternative types of investments in order to bolster the income produced in a large portfolio. This is usually pretty risky, and very few investors understand what they are doing when they agree to it. Sometimes I think that the bond traders likewise do not understand what they are suggesting when they recommend these risky, complicated and supposedly sophisticated strategies to bond investors. I do not recommend them.
Investors sitting on a portfolio of bonds maturing in 5- 7 years should be thinking now about their options. They will need to calculate the income they estimate they will receive, determine whether or not it will satisfy the required minimum distribution rules when they reach age 70 ½ if that will be an issue, and also calculate the potential loss of principal they will realize if they sell their bonds in exchange for other income-producing investments.
This is not an easy task and not to be taken lightly. Their choice is either a low return and no loss of principal or a loss of principal and a plan for a higher return. The only way to make this kind of decision is to crunch those numbers. As unpleasant as these choices are, it is important to know what you are facing and just deal with it now, not later. As we speak, interest rates are on the rise and the problem will only get worse.
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