Bonds are often viewed as investments that are “like stocks but safer.” The reality is that while they don’t typically fluctuate as much as stocks, bonds can be very volatile at times and yes, even lose money. Stocks for example fluctuate up and down but have always trended higher over time. Bonds on the other hand are more like a loan with a balloon payment. I give you $ and you pay me interest until the due date then you give me back my principal. Unlike equity markets, bonds do not typically trend higher. This is called a reversion to the mean. That means that over long periods of time, they will likely return the same amount even though they may perform better over different time periods.
Bonds have averaged roughly 4.5% for nearly 100 years, not 7% that we have become accustomed to since 1983. Bonds can move in very long cycles as opposed to stocks. They can last 20-40 years. Generally, if bond prices have been high for a long time, they will “revert back to the mean” and average a lower than normal amount so that the 4.5% historical average is maintained.
In recent years, mostly due to interest rate declines, bond mutual funds have dramatically increased their positions in High-yield (junk) bonds. High-yield bonds are more risky than regular high credit quality bonds. They do this in order to try to maintain the interest rates the fund used to return when rates were higher. This is dangerous because high yield bonds act more like a stock than a bond. While it still has the characteristics of a bond, its riskier nature makes it fluctuate more like a stock and will often move in value with stock prices. This is known as correlation.
Correlation is a measure of how directly two things move together. Two things that move exactly together are said to be perfectly correlated (+1). The goal of asset allocation is to combine investments together that have little, no, or best of all, negative correlation. So, an increase in high-yield bonds makes bonds more correlated to stocks than ever before, and that is not what most investors think they are buying when they buy bonds.
Rising interest rate periods are typically bad for bond prices. Even though I believe interest rates will stay low for an extended period of time, I would not expect more than a low single digit percent return on bonds as an average for the next 5-10 years. Again, they’ve averaged 4.5% over time and the last 30 years has been 7+%. It’s only logical that bonds will return less in the future if they are to revert back to the mean.
Liquidity — When securities change hands, there has to be a buyer for the seller’s securities. When markets get panicked, high-yield bonds may not have a buyer at a price anywhere near what the seller thought was market price, or he may not have one at all which is known as a liquidity crisis. This is what happened in 2008. The junk bond markets ceased up because nobody wanted to buy something risky in a time of crisis. This is an extremely dangerous situation for markets. If you think bonds can’t lose money, just watch what happens in a situation like this.
Credit quality — The better the quality the lower the interest rate because it’s less likely that the bond will default. While it might be hard to accept a lower yield, better quality bonds with a shorter duration equal the safest bet. While this is no guarantee you can’t lose money, it’s a lot safer than long duration and low credit quality.
Other consideration — Exchange rates, political stability and more.
As you can see, while yes, bonds are typically safer than stocks they aren’t without plenty of risks. They can certainly lose money, and some can even closely mimic stocks. Knowing what bonds you own is very important because of the multitude of different types of bonds in the world today. I would suggest in times like this, you keep your bonds short in duration and high in credit quality and accept that they will likely return significantly less than they have over the last 30 years.
T. Eric Reich, CIMA, CFP, CLU, ChFC is president and founder of Reich Asset Management and can be reached at 609-486-5073 or firstname.lastname@example.org.
The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. Comments concerning the past performance are not intended to be forward looking and should not be viewed as an indication of future results. Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Reich Asset Management, LLC is not affiliated with Kestra IS or Kestra AS.