Bonds Bring New Risks to Beware in Fixed Income
By: Jeff Brown

NEW YORK (BankingMyWay) — It’s one of the basic rules of investing: Divide your portfolio carefully between stocks, bonds and cash to find an ideal mix of risks and returns. But now, one part of that equation – bonds – is throwing the master plan out of whack.

The reason: Bonds now offer far more risk, and the prospect of lower returns, than at any time during the past three decades. Because of that, many investors may be wise to shift part of their bond holdings, perhaps a big part, into simple bank savings or other cash holdings. You won’t make much money that way, but you’ll protect your holdings from losses.

“The last 30 years you haven't had to make a choice in fixed income. It's given you great returns over and above inflation and low volatility. Now every dollar that goes into fixed income comes at a price of really reducing the expected return of the portfolio,” says Michael Jones, chief investment officer and chairman of the RiverFront Investment Group, in a video interview with market-data firm Morningstar.

While many investors expect bonds to produce lower returns than stocks, they also assume bonds are safer. Ideally, they also march to a different drummer, producing positive returns when stocks are in the dumps. That reduces the portfolio’s overall volatility, or risk.

But over the past three decades bonds have produced stunning returns, even though their yields, or interest earnings, have generally been nothing to brag about – especially in recent years. With yields low, the big returns came from rising bond prices. As prevailing interest rates gradually got lower and lower, investors were willing to pay extra for older bonds that were more generous than newer ones. This process produced stock-like returns for many bonds and bond funds.

But now rates are so low they cannot go much lower, with the 10-year U.S. Treasury, for example, yielding just 1.75%. Bonds with shorter terms yield even less.

So how much can investors expect to earn in coming years?

“If you start at 1.5%, history says you're going to get at best 1.5% returns,” Jones says.

In other words, the return will equal the yield, since there won’t be any gains from rising prices. Price gains are extremely unlikely when yields are already near rock bottom.

In fact, bond risks have now gone up, because interest rates have so much room to rise in coming years. When that happens, investors will prefer the newer, more generous bonds to the stingy ones sold today. The lack of demand will cause prices of today’s bonds to fall – the opposite of what happened during the past three decades. In fact, Jones says, the future could look like the 1940s and early ‘50s, when bond investments lost 40%, much of it from inflation damage.

The only way to avoid this is to hold a bond to maturity, when the issuer will pay you the bond’s face value. But that option means locking into today’s low yields for years.

“If you start with rates higher and then they fall, you get a capital gain and you feel like a genius, but if you reinvest at lower yields over a 10-year period, you're going to get back to that starting yield,” Jones cautions.

Investors who are concerned about the future of bonds can load up on stocks, which have done well in recent years. But stocks, too, are risky, so people looking for safety might do better with cash. With the averaging one-year certificate of deposit yielding only 0.25%, you won’t get rich. But you won’t lose money, either, and you’ll have quick access to your money when opportunities arise.

—For more ways to save, spend, invest and borrow, visit MainStreet.com.

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