Wealth Management Insights
      Are Bonds a Bubble Waiting to Burst?
      November 2011
 
Recent market volatility has many investors looking at U.S. Treasurys as a “safe haven” again. However, large reallocations to fixed income assets – which have seen sporadic inflows of nervous investor dollars since 2009 – may bring with them increased risk. If you recently made a reallocation to fixed income assets like U.S. Treasurys or are considering one, there are some things you should keep in mind.
What you should know:
1.
There is no “risk-free” guarantee.
While investments in Treasury debt are widely considered “low-risk” from a default standpoint, investors are at risk to price volatility. If for whatever reason you sell an issue before maturity, you risk loss of principal – especially if interest rates rise between the time of purchase and when you sell.
  • Because bond prices have an inverse relationship with bond yields, if and when interest rates move higher, bonds issued at lower rates will experience price erosion.
  • The 10-year yield on U.S. Treasurys – which stood at 2.1% at the end of October – dipped below 2% in August for the first time in 50 years, indicating bond prices have room to fall.
2.
 Recent investor psychology has favored bonds.
Because bonds are perceived as safer than stocks, the bond market has historically benefited from uncertainty in the equity markets. Between the Eurozone debt crisis and the impending deadline for Congress to address domestic debt issues, there has been plenty of uncertainty weighing on U.S. investors recently.
  • The only real clarity investors have about the future has come from the Federal Reserve, which has vowed to keep interest rates at or near historic lows for at least another year.
  • Like yields, interest rates tend to have an inverse relationship with bond prices, meaning bond investors who embrace a trading approach and expect persistently low rates to keep prices high are further incented to invest.
3.
 Inflation could rapidly deflate the bubble.
What could confound the Fed’s efforts and bond investors is inflation, which has been a growing concern for some economists.
  • In 2011, the inflation rate in the United States (as measured by the Fed’s preferred measure – year-over-year Core PCE) increased from 1.0% in January to 1.6% at the end of September.
  • Because inflation erodes future purchasing power, higher inflation would drive higher bond yields on with longermaturity bonds.
4.
 Maturity can make a difference.
Rather than investing exclusively in bonds with longer maturity dates, you can choose to ladder or combine bonds with varying maturity dates within your fixed income portfolio.
  • Short-maturity bonds in the ladder can lower overall portfolio yield; however, they also can reduce the chances that you may have to liquidate underwater positions if the need to raise funds arises.
  • Short-maturity bonds can also provide investable funds if interest rates rise.
5.
 Riskier investments may actually mitigate bond risk.
While most bond prices are driven by U.S. Treasurys, not all bonds are issued by the government. And, if what you’re seeking is income from your investment portfolio, you have alternatives:
  • High-yield corporate bonds are riskier than investment grade bonds, but could help offset bond losses if and when interest rates eventually rise, as highyield returns have low correlation to Treasury returns.
  • Stocks that pay dividends, while also inherently higher-risk than U.S. Treasurys, can offer a source of current investment income with the additional potential benefits of reduced correlation (stocks tend to behave differently than bonds) and gains from performance over time.
What you should do now:

Making a dramatic reallocation that leaves you heavily concentrated in any one asset class is almost never a good idea. In today’s volatile and uncertain environment, we recommend you review your portfolio with your Financial Advisor to ensure a proper balance of fixed income, equity and other more flexible investment options is at work toward your long-term goals and current income needs.

Stocks and bonds are materially different investments and an investment should not be made in stocks for the sole purpose of attempting to generate investment income. Investments in high-yield corporate bonds typically offer higher yields than investment grade securities, but they also include greater risks including increased credit risk and the increased risk of default or bankruptcy. There is the potential for loss of principal in any investment.

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