Bond lovers may be in for a nasty heartbreak

The rumblings have ramped up: Interest rates are looking ripe to rise. That has several implications for savers, investors and, perhaps especially, bondholders. Robert Johnson, president and CEO of The American College of Financial Services and lead author of Invest With the Fed, shares his thoughts on the situation.

Q: The current bull market is the longest in history. Are you seeing signs that it’s aging out?

A: The interesting aspect of the question is that the assumption is it's a reference to an aging bull market in equities. The real aging bull market is in bonds. Essentially, we have been in a secular long-term bull market for bonds since 1981. It seems that investors are very conversant with developments in the equity markets, yet fail to see the high valuations in the bond markets.

Q: But people often turn to bonds when seeking safety — is that a mistake? 

A: The old adage that stocks are risky and bonds are safe is a misconception. I believe that for a long-term investor there is considerable risk in the bond market at the current time. The thing to remember about equity markets is that they do continue to trend up over long periods of time as economies grow in spite of short-term business cycles.  The Dow Jones industrial average was at 49 in January of 1900 and recently closed at over 18,570. Betting on long-term growth in the American economy has generally worked out pretty well.

Q: Some bonds are delivering attractive yields. Should investors be tempted?

A: One of the worst moves investors can make is to "reach for yield."  That is, some investors have a specified yield target and simply move down the credit quality curve in order to meet that goal.  Oftentimes investors forget that high-yield bonds are referred to as "junk" bonds for a reason.

Q: So are you saying stay away from bonds?

A: I see no compelling case to own conventional bonds at the present time. Conventional bonds decline in price as market interest rates rise. Over the long run, there is a much greater probability of rates rising than declining from current levels. If an investor wanted to take a position in bonds to protect wealth, Treasury Inflation-Protected Securities (TIPS) would be the investment vehicles that I would likely access. As an alternative, some equities with strong balance sheets and growing dividends can help generate income, as long as the price you pay isn't too high.

Q: What alternatives are worth considering right now to bring safety to your retirement portfolio?

A: Never has it been more true that a risk/return trade-off exists in the financial markets. If one wants absolute safety in terms of protecting principal, then either cash or TIPS are virtually the only alternatives. However, in the current environment these assets provide essentially zero return. If you are in the retirement red zone — that is, are five years or less to retirement — at least some percentage held in these assets may be appropriate for you. If you have a longer time horizon, blue-chip, dividend-yielding equities provide both income and potential future capital growth.


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