Boatman: Be careful of your asset allocation; plan ahead
Many investors have been using bonds as a way to remove some of the volatility from their portfolios.
Conservative investors may use an asset allocation of something like 60 percent stocks and 40 percent bonds. It is important to understand bonds and the risk that they have. Bonds have been some of the best performers for the last decade or more.
Bonds are a loan to a company or government and not an investment in them. This means that in the case of liquidation, bond holders get paid before stockholders. That does not mean that bonds are risk free.
General Motors bond holders did not receive the full value for their investment during GM's bankruptcy. There are other kinds of risks associated with bond holdings. Another is call risk. This has not been a big issue for some time.
Call risk is when a company has the right to call before maturity because they can get a lower interest rate. This is the same as consumers who refinance their mortgage when they can get a lower interest rate. Call risk on bonds means that you would probably have to accept a lower rate of interest than you thought.
If you own zero coupon bonds you will have to pay the IRS for interest you have earned but have not yet received. These bonds are sold at a discount and pay the higher value at maturity. You must pay taxes every year on this imputed interest.
Bonds also have a credit risk. The GM case and other bankruptcies illustrate this point. This risk means that you lose some or all of your investment if there was a default.
Bonds also could have an inflation risk. If you are earning 2 percent interest on a current 10-year government bond and inflation goes up to 3 percent you will continue to lose purchasing power. Liquidity could also be an issue.
If you need to redeem your bond early, there may be a limited market interested in buying it. Maybe the company has gotten a credit downgrade or is facing some other issue.
By far the potential biggest risk to the whole bond market is interest rates could rise. This may seem a little strange to you at first since you would think that bond holders would like to earn higher interest rate.
Actually, they would. That is why no one would be willing to pay you face value for your older, lower-interest-bearing bonds. This means that if you wished to sell your bonds to buy higher interest paying options, you would have to take a discount that would allow the new owner to receive the new equivalent interest rate. This would mean that you would not have enough principle from the sale to purchase the new bond. This is duration risk.
The Financial Industry Regulatory Authority has recently issued an investor alert. In event of rising interest rates, “outstanding bonds, particularly those with a low interest rate and high duration may experience significant price drops.” A bond fund with 10-year duration will decrease in value by 10 percent if rates rise by one percentage point. We are currently at historically low interest rates.
Longer term bonds are more sensitive to this than short term. Duration measures more than time and also measures volatility as interest rates move.
Most investors today have never had to invest in a time of rising interest rates. Since the fourth quarter of 1987, interest rates have fallen. Before that, they had risen for 31 years. Rates cannot go much lower; they are near zero right now.
Last week, we saw a huge reaction in the stock market at just the suggestion that the Fed may discontinue its low rate policies.
Who is going to buy all of the already issued bonds?
Once the quantitative easing is discontinued and the Fed starts selling instead of buying government bonds, there could be financial shock waves. Be careful of your asset allocation and plan ahead.
Gary Boatman is a certified financial planner and local businessman who serves as president of the Monessen Chamber of Commerce.