Bonds are no longer safe haven
Historically, bonds have been viewed as a secure investment. Bonds issued by governments of major, mature nations, such as the United States and Great Britain, are considered “risk free” from default, as they never have. Unless bonds are held to maturity, however, there is interest-rate risk. If an investor sells before maturity, a loss is possible if rates rise.
The credit ratings of the United States and Great Britain were downgraded by some agencies last year. But the prospect of rising interest rates threatens the market prices of all conventional bonds not linked to an index that adjusts returns with inflation.
Pacific Investment Management Company (PIMCO) manages assets of $2.04 trillion. According to analyst Morningstar, 90 percent of PIMCO assets are invested in bonds. The world's largest mutual fund is PIMCO's Total Return Fund, which suffered redemptions of $10 billion in June alone.
On June 28, PIMCO's founder and CEO William H. Gross, who has taken to sharing his thoughts on Twitter, said: “We like bonds here. They won't make you rich but the May/June experience is unlikely to be replicated in 2013.”
When it was suggested that interest rates might turn downward again, however, Craig J. Ferrantino, a Long Island financial adviser, sold 15 percent of his clients' PIMCO assets.
At a time of rising interest rates, the fixed yield on a conventional bond becomes progressively uncompetitive and its market price falls. In an environment of falling interest rates, bond prices rise.
To encourage continued economic growth, many governments moved their domestic interest rates downwards. Americans have enjoyed almost 30 years of flat or decreasing interest rates. This translated into perhaps the greatest-ever bull market in bonds.
The Federal Reserve in recent years has instituted a program of bond-buying called quantitative easing. A key part is buying vast amounts of Treasury bonds to drive up bond prices and move yields, or interest rates, down.
Despite the size of the program, it appears to have had questionable impact on job creation and real economic growth. Doubts about quantitative easing's efficacy were expressed by some Fed Open Market Committee members. This caused bond yields to bottom as prices peaked on April 29, 2013.
Last month, Fed Chairman Ben Bernanke said that if economic improvement continues, the central bank might scale back its $85 billion a month bond market subsidy. “We would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year,” he said.
To some, Bernanke's statement may have sounded mild. But it was enough to cause a wave of panic for some investors. Without the Fed's financial heroin, interest rates would rise sooner than expected, they feared. As a result, bonds, equities and gold fell rapidly. The bull market in bonds appeared threatened.
Whatever the future, last month's bond market panic should have alerted investors that after a 30-year bull market run, rising interest rates threaten the market price of even the highest quality bonds not held to maturity.
John Browne, a former member of Britain's Parliament, is a financial and economics columnist for Trib Total Media. Email him at firstname.lastname@example.org.