Does Investing in Bonds Still Make Sense?

In order to encourage lending and help jumpstart the economy out of recession, the Federal Reserve has kept the federal funds rate — the interest rate on overnight loans between banks -- close to 0% for the last 18 months. During that time, with stocks still relatively volatile and cash funds offering extremely low yields, investors turned to bond mutual funds to net higher yields. In 2009, investors pumped nearly $400 billion into bond funds and another $112 million through May 5, 2010.

The question is, how long will this bond-friendly, low-interest-rate environment last? Many experts believe rates have no place to go but up. As the economy gains strength, the Fed may hike rates to guard against inflation. When that happens, bond investors need to understand how their portfolios could be impacted in a higher interest-rate environment.

A bond has a price and a yield, which move in opposite directions -- when bond prices rise, yields fall (and vice versa). Bond prices have a similar relationship with interest rates. When interest rates fall, bond prices typically rise, and vice versa. Consider what can happen to your bond values if interest rates rise. Let’s say you purchased a 10-year Treasury bond today at a price of $1,000 and a yield of 3.5%. That bond will pay you $35 every year for the next 10 years, at which point you’d get your principal back. Now, let’s assume that next year you decide to sell the bond, when interest rates will be higher. Your yield would be higher, say 5.0%, but no one would pay you full price for your bond with a 3.5% yield when they could purchase a new bond with a 5.0% yield. So, the price, or value, of your bond would drop from $1,000 to roughly $900. The longer a bond’s duration, the more its value will fall when rates rise. On the other hand, if you are entirely in short-term bonds, you will have less price olatility, but also lower yield.

So, what should investors do? Take a long-term view and don’t attempt to time the market. By holding bonds or bond funds for the long term, investors can largely make interest-rate movements irrelevant. Much as with stocks, investors can ride out the ups and downs of interest rates over time, and receive the full price and yield of the bond at maturity.

The majority of our clients hold bond funds rather than individual bonds. Right now, the average bond portfolio we manage is a mix of short-term and intermediate-term bonds. This way, we dampen volatility with short-term bonds, while picking up the greater yield offered by the intermediate-term bonds. We call it the sweet spot of the yield curve -- a spot that could change as a result of rising interest rates.

The acceptable tradeoff between risk and return will vary from individual to individual. But long-term investors shouldn’t be frightened out of bonds because of the possibility interest rates may rise. With a long-term view, and the right strategy, bonds can play an important role in total-return portfolios, regardless of the interest-rate environment.