A properly diversified portfolio will normally contain some amount of bond, or bond fund exposure. Bonds are contracts between an entity, i.e. company, municipality, or government and an investor that lends money to that entity. The entity agrees to pay the investor interest over an agreed upon time period and at the end of that period, the entity agrees to repay the investor’s principal in full (as long as the entity is solvent and able to do so).
The Bond Landscape
Back in 2003, the Federal Reserve Open Market Committee (FOMC), which sets the interest rate in the U.S., started to lower key interest rates to try to stimulate our economy out of the recession. In doing so, they made home-buying much more affordable. With interest rates low, banks had difficulty meeting their margins and started implementing some questionable lending practices which caused the sub-prime loan crisis, eventually leading to the financial disaster of 2008.
The FOMC then decided that one way to salvage the situation was to continue lowering interest rates and also embarked upon a series of different Quantitative Easing programs in an attempt to stimulate the economy and save us from another Great Depression. Needless to say, our Federal Reserve rate has been pegged at 0% for the past few years, and this past September, Federal Reserve Chairwoman Janet Yellen let the public know that there would be no more easing programs and that she would soon raise interest rates, if the economy could sustain the increase.
Why This Matters to Investors
1. In a decreasing rate environment, the value of current bonds increases because everyone wants the bonds that were issued a few years ago when rates were higher, therefore driving up the price of the bonds due to excess demand for the higher interest rates.
2. In an increasing rate environment, the value of current bonds decreases because no one wants the older bonds that were issued when rates were really low – they want the new bonds with higher yields.
I believe we are experiencing an interest rate bubble that will at some point start to deflate. I also believe the FOMC is going to do their best to have this balloon deflate slowly, but there is a chance that when interest rates start to go up we could see a rush to the exit of everyone who has purchased interest rate-sensitive investments. If that were to happen and a surplus of people tried to sell their investments at the same time, we could see rates really start to move to the upside and bonds start to precipitously lose value.
What to Do
I am not saying that investors should immediately sell their bonds to get ahead of the crowd. Who knows? Interest rates could stay lower for much longer. What I would encourage all investors to do is meet with their financial advisors to solidify a game plan, ask about alternatives to using bonds to help balance their portfolios, and keep a very close eye on bond yields.
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