Bonds have traditionally played two roles in an investment portfolio: 1. to provide income and 2. offer a measure of safety and stability to balance out the more volatile performance of stocks. However, record low interest rates have wiped out much of that income production while raising the potential volatility of bonds. The fact that they may not be well suited to either role these days presents investors with a challenging dilemma.
This means that investors need to rethink traditional assumptions about the role of bonds in a portfolio, and lower their expectations about what returns to expect from this asset class.
Potential problems with bond investments
Here are some of the potential problems with bonds these days:
1. You can't get to past yields from their current levels
Historically, 10-year Treasury bonds have earned investors about 5 percent a year on average. These days though, 10-year T-bonds are yielding about 1.59 percent, according to the U.S. Department of Treasury Resource Center. The only way they could earn a 5 percent return is if some price appreciation were added to the income yield. That would require interest rates dropping even lower than today's level, which does not seem likely. Also, that would be a temporary boost, but the added return could not be sustained over the lifetime of the bond. In other words, you cannot really get to a 5 percent long-term return from a 1.59 percent yield.
2. High-quality bonds still safe, but may have some volatility
Extremely low interest rates make bonds very sensitive to rising interest rates, which would drive prices down. High-quality bonds can still be counted on to pay off at par upon maturity, but in the meantime prices could be subjected to some wild swings. So, high-quality bonds are still safe over the long run, but may expose you to some year-to-year volatility.
3. Guaranteed losses
Some global interest rates are so low they are actually negative. Investors have to be so desperate for somewhere relatively safe to park their money that they will pay for the privilege of doing so. However, this runs counter to the idea of investing as a means of building wealth.
4. Default spikes
As an alternative to the paltry yields on high-quality bonds, you could earn more yield on lower-quality fixed income securities. Be advised, though, that current default rates are deceptively low, which may cause investors to underestimate the risk of high-yield bonds. Default rates during recessionary periods can send them soaring into double digits. Defaults of that magnitude can be devastating if your bond holdings are not sufficiently diversified, and even then they can wipe out any yield advantage offered by lower-quality bonds.
It is not just default rates that may be lulling investors into complacency these days. Inflation has also been unusually low in recent years, but any bond investor should recognize that inflation is a bond's worst enemy. Low yields leave precious little cushion against a revival of inflation. Even a return to normal inflation would swamp today's interest rates, and flare up of 1970s-style inflation would decimate the bond market.
6. Bad policies
Investment policies routinely specify asset allocation guidelines that are based on historical returns, but as noted above, recent yields have more or less rendered historical bond returns irrelevant. This means that many investors are working within policies derived from outdated assumptions.
4 investment alternatives when facing low bond yields
How do you respond to these conditions? There are investment alternatives, though all of them are somewhat limited:
1. Higher stock allocations
A lower expected return from bonds might influence investors to shift some assets from bonds to stocks. However, the low interest rate conditions that represent such a risk to the bond market are also helping prop up the stock market. Rising bank rates could clobber stocks and bonds at the same time.
2. Sacrifice bond quality
Higher yields are available in lower grade bonds, but with the economic recovery ongoing, it may be time to start worrying about the next recession.
3. Search for CDs
You might be better off in certificates of deposit (CDs) than in short-to-intermediate bonds. The most competitive 5-year CDs are paying in the neighborhood of 2 percent, which beats most yields on Treasuries of 10 years and shorter.
4. Increase savings
No one likes hearing this solution, but raising retirement deferrals may be the only sure way of making up for sub-normal bond yields.
Bonds still can add diversification to a portfolio, as well as deliver a somewhat diminished version of their traditional income and safety characteristics. Investors just need to be forewarned that they may have to accept more volatility and less income than historical bond returns would suggest.
Comment: Have low bond yields affected how you approach your investment portfolio?
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