(Bloomberg) -- Most individual investors know some basics about bonds. They know the diversifying role fixed income plays in a portfolio. They know bonds are generally less risky than stocks, and they know the cardinal rule of investing in credit: When yields go up, prices go down.
But ask them to go much further, and many balk. Why, specifically, are yields and prices inversely related? What does it matter if yields on 10-year Treasuries climbed more than 100 basis points in three months? And if the bond indexes are tanking, should you sell?
To answer these questions, at a time when bonds are getting more attention than they have in years, Bloomberg News called financial advisers to ask what they wish they could tell their clients.
About those plunging prices
Bond-market dynamics are harder for many to intuit than those of the stock market. That often leaves people talking past each other. Jennifer Lammer of advisory Diamond NestEgg in New York recently cringed when she heard an interview in which one person said “bonds are up” as if it were a good thing and another called it bad. Only later did they realize one person was talking about prices and another yields. But if you can clarify which element you’re discussing, and understand why bond yields and prices move in opposite directions, you can make sense of the market.
Essentially, it boils down to competition with a time-horizon twist. A bond’s yield is the amount of money a new investor can expect to earn each year until the bond matures as a percentage of his or her initial investment. While the actual coupon payout an investor receives doesn't fluctuate, the yield will vary in order to reflect the bond's value as interest rates rise or fall.
Investors planning to hold bonds until their maturity can pretty much stop there. You loan money to an issuer — usually a government or a company — you get annual interest for it in the form of a coupon payment, and then you get back the amount you loaned at the end. (As long as the issuer does not go bust.)
But things change if you want to sell that bond on the secondary market before it matures. Maybe you need cash for a life event such as a home purchase or retirement. What makes this part more complicated is that the value can change when you sell it, depending on interest rate expectations.
This is where competition comes in. If new issues of bonds — or even simple bank accounts — are offering higher yields than an older bond because of a higher interest rate environment, that bond will now be worth less on the secondary market. Higher yields are great for buyers of new bonds. But it’s bad news for people who want to sell bonds previously issued with lower coupon payments, as is the case now.
Bond funds
Another reason people can get tripped up when discussing fixed income is the fact that most Americans don’t own individual bonds or Treasuries, explains Ira Jersey, US rates strategist at Bloomberg Intelligence. Instead, they most often own fixed-income securities through 401(k) accounts that are indirectly backed by bonds or tracking the price of them.
This means many Americans may be noticing a decline in the fixed income portion of their portfolios this year, reflecting the decline in value of previously issued bonds on the secondary market. So while it was a great year to buy new issues of bonds directly, popular bond funds found in 401(k) retirement accounts are down for the year including American Funds Bond Fund of America (ABNFX), Baird Aggregate Bond (BAGSX), and Dodge & Cox Income (DODIX).
What to do
This could have you wondering if you should sell those bond indexes or change how you allocate future investments. Financial planners generally advise investors against doing anything drastic. In fact, forecasts of a looming recession could bode well for investors’ bond holdings. That is because the forces that drive down bond prices when interest rates go up, work in reverse when they go down.
“I wouldn’t be making decisions based on the last two years of bond performance,” says Eric Roberge, founder of the Boston-based financial planning firm Beyond Your Hammock. “In this case, you could argue that bonds are well prepared to do relatively well now that they’ve gone through what can be described as a big reset.”
Expectations the Federal Reserve may be close to done with its interest rate hikes may mean bond yields have reached their top. Rate cuts could be getting closer, and that could trigger a recovery for bond funds, Lammer said.
Chasing yields
Laura Mattia, chief executive of Atlas Fiduciary in Sarasota, Florida, said the biggest mistake she sees clients make with bonds is chasing yield, especially with corporate bonds. Recently elevated yields and low prices have made some investors think they can use bonds to generate the same returns that they might get from stocks, but with lower risks. There are a few problems with that assumption, however.
First: Higher yields can be a sign a bond investment or fund is too risky for the average investor. This is especially the case with companies that are in distress. In order to attract investors, they need to offer higher yields. But this reward comes with the risk that a company may go under and end up unable to pay back investors anything at all.
Second: Some bond yields change over time, particularly if they are linked to inflation.
“I bonds were really popular for a while when their interest rates were almost 10%,” said Dennis Nolte, a financial consultant with Seacoast Investment Services in Winter Park, Florida. “A bunch of people read the articles and put their $10,000 into I Bonds online and didn’t realize that the interest rate moves every six months.”
Now I bond interest rates are sitting at 5.27% and investors, and investors not only must hold I bonds for at least a year, but will lose interest from the prior three months if they cash them in before five years.
Third: Yields mask tax implications. Corporate, government and municipal bonds all face different liabilities. Income from corporate bonds is usually taxed at all levels; government bonds only at the federal level; and municipal-bond income is generally untaxed at the federal and state levels, depending on where you live. This means that a corporate bond with a high yield may actually bring an investor lower real returns versus a (possibly less risky) municipal bond once taxes are taken into account.
So, for the average individual investor — it’s best not to exit an asset class just because it has not been performing well recently, says Mattia.
“Investors need to have the discipline to stay with a well diversified portfolio that has been developed strategically,” she says. “In the long run, they will be rewarded. Remember correlation is dynamic and bonds will perform.”
To contact the author of this story:
Charlie Wells in London at [email protected]