Panic? – Stocks and Bonds Falling in Harmony
I got a call from a panicking client last week regarding the drop in his account value. I told him bond prices have been headed down. “What about stocks”? he asked. Whoops, I thought when stocks went down, bonds were supposed to go up in value to offset the stock loss. Lately, that has not been the case. The correlation between stocks and bonds has reached the highest level in years, which makes it very difficult to create a diversified, minimally correlated investment portfolio.
Yesterday, the benchmark 10-year U.S. Treasury Bond yield came within shouting distance of 3% when it reached 2.884%. While that is not a historically high rate it is a 79% increase from the 1.61% rate in May.
How does this effect bond prices?
Imagine you bought $100,000 worth of U.S. T-Bonds in May that promised to pay 1.61% or $1,610 in annual income.
Three months later, that same bond yields 2.88% or $2,880 for the same $100,000 investment.
If you wanted to sell the bonds you bought in May, nobody would pay $100,000 for them. The market price would be whatever $1,610 in annual income would equal at a 2.88% yield (like the new bonds for sale).
The equation to determine the current value of the bond bought in May is: x/.0288=$1,610
BOND VALUE = $55,902. Even if you don’t sell, the lower bond price is reflected on your investment statement.
Obviously, bond prices got hammered when interest rates went up 79% in just a few months. This might actually be a buying opportunity for bonds at these lower prices, or is just the beginning of a long-term upward cycle in interest rates?
A spike in interest rates does happen from time to time as you can see by looking at the chart. With rates being low, the real changes in rates produce a higher percentage change than it would be if/when rates were higher.
Unfortunately, stock prices have dropped four days in a row while bond prices also fell. Unlike bonds, stocks are not beholden to interest rates, but rising interest rates may hold back prices as they can negatively impact the future profitability of many corporations. For instance, higher interest rates will hurt the housing market as mortgage applications have slowed down quickly in response to the spike in mortgage rates.
Stocks have had quite a run the past several years (the DOW began the year at 13,000 and is currently at 15,000) and are certainly not priced nearly as attractively as they were after the market sunk to 6,600 back in 2009. There are still plenty of companies that are growing their bottom lines and will continue to be solid long-term investments.
If stocks and bonds are going to move together, you may want to add other asset classes to your portfolio such as commodities and commercial real estate. Last week stocks and bonds were down, while gold and silver spiked up in value. In order to have a “diversified” portfolio you need to own assets that move in different directions (uncorrelated).
If you would like me to review you portfolio and help you understand the risk in your portfolio I would be happy to do so at no charge.
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