Q.: With rates so low, why would anyone own bonds? Won’t bonds get crushed when rates rise?
— Paul in KC
A.: Paul, if you are looking for interest payments, bonds are underwhelming for sure. If you are looking for growth over the long term, bonds are a poor choice.
However, if you are looking for stability, bonds can work well. Some want stability to lower the volatility of the value of their portfolio which helps them sleep better and avoid panic when stocks sink. Others like to have “dry powder” to use to buy more stocks during drops in stock prices. Others still like to have a source of cash for shorter term needs, so they don’t have to sell when stocks slide. Structured well, a bond portfolio or a mutual fund holding bonds will not be perfectly stable like cash, but it can provide more earnings than cash without exhibiting the swings in value you see in other investments like stocks.
As for the dangers in owning bonds, there can be many, but if the goal is stability, the risks can be managed. Like life, investing presents trade-offs. The basic trade-offs for bonds are the same regardless of the level of interest rates. Higher yield equals higher risk. If a government bond is paying 1% and another bond maturing at the same time pays more, you better understand why before you buy.
Bonds are debt obligations of the issuer. When you buy a bond, you are buying debt and become a lender. The issuer owes you interest and a maturity value on specific dates. Because the terms of the bond are contractual, you can quantify and assess their risks more reliably than ascertaining the risk/reward trade-offs in something like stocks.
The risk most people are talking about now is interest rate risk. One way to get larger interest payments is to buy bonds that mature farther out in the future. It is not always the case, but longer maturity bonds usually offer higher yields than bonds maturing sooner.
When interest rates rise, the value of bonds drop. Longer term bonds drop further than shorter term bonds. A calculation called “duration” will give you an idea of how big such a drop can be.
For instance, a 30-year U.S. treasury bond has a duration of about 21 years. This means if interest rates instantly rose 1%, the value of the bond is expected to drop about 21%. A one-year treasury, on the other hand has a duration of about 1 and would be expected to only drop 1% in value.
The one-year bond doesn’t drop as much because its owner need only wait one year to receive the full maturity value. When the one-year bond matures, the proceeds are free to be used as the owner likes. The owner of the 30-year bond is still stuck with lower payments for decades and thus would get a depressed value if sold.
Another common way to get more yield is to buy bonds from issuers with lower credit ratings. Caution is warranted here too. If a bond offers higher interest, it is because there are some doubts about the issuer’s ability to pay on time.
If you want stability for some portion of your portfolio, a diversified array of good quality bonds with a reasonable duration, can achieve that goal. However, if you are looking at bonds for higher interest payments, you must be willing to take on more risk of loss. If you are looking for long term growth, diversified stocks have been a better choice.
If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line.
Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide but with offices in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.