Most people know that many bonds have what’s called an “inverse relationship” with interest rates. That means if interest rates go up the prices of bonds go down and vice versa. Let’s suppose you went to the bond store and bought a new bond for a $1000 that would pay you 4% interest (the coupon rate) for the next 20 years. At the end of twenty years the bond would mature and the bond store would give you back your $1000. Your risk would be that the bond issuer got in some kind of financial trouble. In the worst case scenario your bond could become worthless. It may not happen often, but it does happen.
But let’s say everything is going according to plan and you need to sell your bond before it matures. No problem- you get your coat on, grab your bond, and go back down to the bond store. As you enter there’s a big sign behind the customer representative. Because interest rates have gone down, the sign says that new bonds are paying only 3%. You have a bond for sale that pays 4%, so it’s worth more than the new bonds. If new bonds were paying 5%, your bonds would be worth less. That’s the way it works. You probably knew all this.
A lot of people hold bonds as investments because of the yield or the asset allocation of their portfolios.
Because the economy is in a recovery mood - however tepid, and because of the Fed’s action of “quantitative easing”, we may be seeing a rise in both inflation and interest rates in the not too distant future. Remember, interest rates up, bond prices down. Bond prices down and the portfolio suffers.
All of this of course goes deeper than just the holiday season. Consumer spending is an important ingredient in giving some legs to the recovery and if people are starting to open their wallets for what goes under the Christmas tree, they might be starting to shake off the recessionary blues.
Then there’s something called the S&P Consumer Discretionary Index that tracks among other things consumer spending in autos, hotels, and restaurants. The November 15th report indicated increased demand in nine of out thirteen categories led in a 5 percent increase among auto dealers. It was the strongest performance since the “cash-for-clunkers” program in August of 2009.
So the question becomes how we keep our portfolios in balance and at the same time find opportunites in bonds. I know you have a lot of other things to think about, but you should squeeze in some time to think about this one. I’m here to help this process.
It’s not too difficult to figure out that bonds move the way they do because of the fixed interest rate. If bond interest rates moved upward when inflation and interest rates became higher, we’d have bonds that would have an easier time both maintaining their underlying value and have increased yield. You probably think I’m going to tell you such bonds exist. You’d be right.
Let’s start with Treasury Inflation Protected Securities (TIPS). These are issued by the U.S. Government. That is generally considered a good thing in terms of credit worthiness. I don’t think I’d feel the same way if I lived in Greece or Ireland, but here in the United States, it’s a warm and fuzzy feeling. TIPS have an inflationary “kicker” built right into them. Their “par” value rises with inflation as measured by the Consumer Price Index.
Floating Rate Bonds can also be your friend if interest rates rise. As their name implies, the interest is tied to a rate that rises with interest rates.
Both TIPS and Floating Rate Bonds can be held in a number of different fashions. You should understand that both TIPS and floating rate bonds work best with increasing interest rates and inflation. If rates are decreasing, these types of bonds are probably not your best bet.
My belief is that interest rates will be going up and it’s better to get ahead of the curve than behind it. If you want to learn more, email me or call me at the office.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.