Boatman: Bond situation starting to change
What a week on Wall Street.
The Dow has dropped about 700 points since last week. You hear some traders asking is this a buying opportunity? I guess we know those people will think anything is a good opportunity since they make money every time you buy or sell. This week, I promised to discuss bonds. Many investors consider bonds to be the safe part of their portfolio.
During the last decade or more bonds have out performed the stock market. In fact in the last five years, long term treasuries have even out performed the stock market. Remember, we had to make up the huge drop in stock prices during the great recession. Following this rally, stocks are about the same price as before the recession. Bonds have enjoyed such good returns because they had great tailwinds behind them. Just as an airplane takes less time to fly the same distance with tailwinds than it does to fly into the wind; bonds have benefited. The situation is starting to change.
Many investors have never been in the market at a time of rising interest rates. When interest rates rise, bonds prices fall.
This happens all of the time. If you owned a bond that was worth $10,000 that was paying 5 percent, you would earn $500 per year. If interest rates were to rise to 6 percent, you would like to earn the higher rates just like everyone else. If you were fortunate enough to have your bond mature at exactly this time, there would not be a problem. You would receive your investment back from the issuer and simply re-invest it in the new bond. Most likely, this would not be what happened.
You would have to take your bond to the imaginary bond store to sell it. If you wanted someone else to buy it so you could reposition your money into the high-paying option, do you think you could find a buyer? Not for $10,000, which is your face value.
If you were in the market to buy a bond and could get 6 percent somewhere else, that is what you would want. They will be willing to buy for a price that gives them the same effective yield of 6 percent. That would be $8,333. To calculate this value, divide the interest ($500) by the new interest rate (6 percent). If held to maturity, the new purchaser would receive $10,000 from the issuers as long as they did not default.
Longer term bonds are more sensitive to interest rate increases than short term bonds.
U.S. Government bonds are considered the safest investment because they are backed by the full faith and credit of the government. These bonds are sold at an auction. Like all auctions, if there is more demand to buy, prices stay low. If there is less demand, prices will rise because the issuers have to offer more to attract investments. The Fed has been buying $85 billion dollars' worth of bonds every month. When this source of funds exit the market, prices will rise. The current volatility started when Ben Bernanke said the Fed may start reducing purchase this year. Once the Fed gets to the point where it starta selling the huge quantity of bonds that it owns, interest rate must go much higher.
The other two factors that affect bonds are credit quality and inflation. Detroit declared bankruptcy recently, and it is expected to re-pay bondholders 10 cents on the dollar. Inflation can also affect bond prices, so keep aware of any increases there. Money is pouring out of bonds right now. Be sure that your safe money is really safe. Many people will be surprised when they receive their next brokerage statement. Look at other options if you see this happening. Your broker may not want to discuss these options because they are not something that his or her company offers. There are other options available that might serve you and your family better.
Gary Boatman is a certified financial planner and local businessman who serves as president of the Monessen Chamber of Commerce.