Are bonds a good investment in today’s interest rate environment?
Based on the recent US Federal Reserve decision to taper (reduce) its bond buying program by $10 billion, bond investors are wondering whether to buy and stay invested in bonds, or sell down their bonds investments.
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Included on their tapering announcement, the Fed stated they could take further measured steps to reduce their bond holdings, but stressed they would continue buying bonds "at a rapid pace" after the taper.
As reported by CNN Money, "the tapering by the Federal Reserve won't be a big shock for bonds, because there is still plenty of easy money in the global financial system," said Rick Rieder, chief of fixed income at BlackRock. Still, he expects interest rates to move higher over time, with the 10-year yield reaching 3.25% by the middle of 2014.
As seen in the below chart (courtesy of Bloomberg), yields for US Treasury Bonds, US Agency Bonds, Corporate Bonds and USD MBS Bond Index have been rising since September.
Yields are beginning to rise
Generally, bonds prices go down when bonds rates go up.
In most cases, however, bonds investors do not wait for the actual event to happen before taking action.
Across financial markets, this is a concept referred to as "making a bet based on future rate expectations."
Impact of future expectations on bond investments
Future rate expectation is a key variable used by small and large bond investors to determine whether to buy or sell bonds, and in analyzing whether a bond is a good investment.
When bond investors expect interest rates to rise, they start bidding down bond prices. The opposite holds true when investors expect rates to fall.
The above happens because of how investors derive the present value (PV) of a bond investment: sum total of all future payments discounted by expected future interest rates.
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Investor expectations on Further Fed tapering in 2014
As reported by Reuters, investors expect “the Federal Reserve to reduce its monthly bond purchases to $25 billion by July of 2014 and to end the program at the October 2014 meeting.”
Fed tapering – impact on bond buying and investments
Fed tapering means a reduction in bond buying by the Fed, who has become a major player in the bonds and treasury markets.
The goal of the Fed QE program has been to reduce long term interest rates and spur consumer borrowing and spending.
Tapering will push rates higher, which subsequently leads to lower bond prices and value.
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In calculating the present value of a bond investment, a higher interest rate (discount rate) reduces the current value of that bond.
In anticipation of such a scenario, institutional bonds investors have started rushing for the exits, so as to minimize taking losses on their bonds holdings.
Bond investors are not very comfortable
Waiting until after the Fed decides to completely end its QE program could mean huge losses for bonds investors, especially those with large bonds investments.
This is a key reason why some investors are preempting that end date by moving money away from bonds.
As reported by MarketWatch, “the reckoning isn’t here yet, but bond funds’ losses have offered a grim glimpse of what could be. The largest bond fund, Bill Gross’s Pimco Total Return, shed 2.2% last month — its worst month in four years”.
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What should you do? Buy bonds or seek opportunities elsewhere?
In its latest FOMC meeting minutes, the Fed reported that they will continue to watch incoming information on economic and financial developments.
Fed: “the committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.”
As a bond investor who might have a sizable or not so sizable portion of your investments in bonds, you should keep a very close watch on interest rates.
In their minutes, the Fed also announced that the US economy continues to “grow moderately and some indicators of labor market conditions have shown improvement. However, rising mortgage rates and government spending cuts are restraining growth”.
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If you agree with the general expectation that interest rates will continue to rise, then it may be time to lighten up on some of your bond holdings and rotate the money into other investments - like dividend paying or high-growth stocks.
On the other hand, if you believe the economy is still struggling, and that the current low-interest environment will persist for a while, then switching out of bonds now may be premature.
In either case, the trick to surviving any real or perceived "Great Rotation" is to always hold a diversified portfolio.
Like other fixed income investment vehicles, bonds will always hold a valuable place in any portfolio.
Just exactly how much weight should bonds have in any portfolio? This depends on your individual investment circumstances, as well as in the (rising or declining) trends of interest rates.
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