Is the Sky Falling as Bond Prices Tumble?

All-time low interest rates = all-time high bond prices

All-time low interest rates = all-time high bond prices

The financial headlines the past few weeks have been cluttered with articles about interest rates rising and bond prices falling.  The lower prices are reflected in your bond mutual fund holdings.  This includes U.S. Treasury Bonds, corporate bonds, municipal bonds, GNMA’s, TIPs and other fixed income investments. To no surprise to me, this came right as public money was pouring into bond funds at a record pace.    Bond Prices at Nose-Bleed Levels – Public Jumps in With Both Feet

Interest rates have been rising since May 2, when the yield on the bellwether 10-year Treasury note hit 1.63%. This week, the 10-year T-note yield hit 2.23%  This is the highest it has been in fourteen months. Is it a coincidence that this happened as the public was poring money into bonds as prices hit record highs?

While interest rates have moved about 1/2 a percent higher many bond mutual funds have seen their share price drop by 3-5%.            Is it time to panic?

If you look at the historical interest rate chart below, you will barely see the bump in rates I just mentioned, especially when compared to the decline from a peak of nearly 16% thirty years ago.

What’s the likely reason for the rate increase?

The administration thinks that low-interest rates will help the economy make a comeback. It wants to keep mortgage rates super low as well as keeping the COL (cost of living) increases down by keeping inflation low.  Ben Bernacke and the Federal Reserve have been artificially keeping interest rates low by buying $85 billion dollars of U.S. bonds per month.  Bernacke hinted last month that they may ease that policy in the near future at a meeting last month and that seems to be the driver of the interest rate increases.

As you can see from the graph, there have been many other times that interest rates jumped up, only to head back down.  Predicting the future in interest rates is just as difficult as predicting stock prices in the short-term.

I have been wary of our historically low-interest rates for some time and taken a defensive minded stand by having client portfolios well diversified in their fixed income holdings.  Most bond funds have made very handsome returns as interest rates have come down.

One way to be play it cautiously is to keep the maturity or “duration” of your bond portfolio relatively short-term.  if rates go down your return would be smaller than a long-term bond portfolio, but if/when interest rates go up, the losses will be less.

The Federal Reserve really holds the cards and Bernacke has stated if/when the economy heats up and Unemployment gets to 6.5% he will cut back his bond buying.  I don’t see us getting to the 6.5% number for some time as we are currently at 7.6% with millions of people having given up on looking for a job.

Bond prices might fall a little more before they level off or go back up.  When the economy actually makes significant improvement or when the weight of our National Debt becomes too heavy, we could see a long-term increase in interest rates, but that is a ways off.





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