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D. Frank Norton: Bonds: perhaps not the safest investment

It's Your Money

Posted: October 6, 2010 7:34 p.m.
Updated: October 7, 2010 4:55 a.m.
 

Over this past year, fixed-income investments in U.S. Treasury, municipal and corporate bonds have performed very well while the stock market has languished. For those who invested in 10-year treasury bonds over the past year, they received annual interest yields of between 2.5- and 3-percent and bond values increasing up to 4 percent or more.  Not a bad return when compared to the stock market. 

What’s ahead?
Let’s focus on U.S. Treasury bonds for now.  Ten-year treasury bonds are currently yielding close to 2.5 percent, while 30-year treasury bonds are yielding 3.7 percent. Both investments are close to record low yields.  We may be seeing rising bond interest rates in the not too distant future. 

Impact on bond values
Factors that might influence the rise in bond interest rates:

Improved economy: If the economy improves, thus adding impetus to rising stock prices, there would be a shift of investment dollars from treasuries to stocks, where better returns could be had.  A reduced demand in treasury bonds would drive interest rates higher and bond values lower.

Government-bond purchases: The Federal Reserve has been buying treasury bonds in an effort to keep bond-interest rates down.  If they should stop supporting Treasury bond prices, this could add impetus to bond interest rates rising.

Investment shifts: Yields are so low now that investors shift funds out of bonds into other areas where returns might be higher. Investors’ frustration with such low returns may cause many to simply shift investment dollars to other investment areas such as precious metals, high-yield bonds, as well as some segments of the stock market.

Inflation: If inflation should come back with a vengeance, bond interest rates could be driven up dramatically.

 Rising interest rates on bond values can be damaging.  For example, if we should see 10-year Treasury bond yields (interest rates) move from their current level to 4 percent, in the next year or so, we would see a bond value decline of 7 percent or more on 10-year treasury bonds; and a decline of over 10 percent on 30-year treasury bonds.  Corporate and municipal bonds may see similar declines in value. 

We have seen bond values decline significantly in the past. From June 10, 1979, to Sept. 30, 1981, 10-year treasury bonds declined 10.8 percent as a result of the Federal Reserve Board’s raising the federal funds rate to 22.36 percent back then. 

Between Oct. 31, 1993, and Nov. 30, 1994, we saw 10 treasury bonds decline 10.6 perecnt in value as the economy recovered under President Clinton.

Between May 31, 2003, and July 31, 2003, we saw treasury bonds decline 8.2 percent when the Federal Reserve Board raised interest rates in anticipation of a better economy and concerns about rising inflation.

So there definitely were periods when treasury bonds for one were not good places to be invested.

Protecting investment: Steps one can take to protect bond-investment dollars, particularly treasury bonds, are:

Shorter-term bond: Reduce our allocation to longer term bonds (particularly treasury bonds).  Move those investment dollars to shorter-term treasury bonds (with lower yield), where the bond value will decline much less.

Cash equivalents or CDs Move some funds out of bonds altogether and into cash-equivalent money-market investments or bank certificate of deposits (with very low yields).  You won’t get much return, but you should see your principal hold steady.

Stocks: Move some funds into the stock market taking care to pick market sectors.   There is a higher risk, but greater reward potential.

Precious metals Move some funds into precious metals, either by buying the metal itself or buying stocks of precious metal mining companies.

 Final word:  Do not look at bond investments as safe haven investments going forward.  Consider reducing investment allocations currently in bonds.

D. Frank Norton is a CPA, Money Manager, and Certified Financial Planner in Santa Clarita. “It’s Your Money” appears Thursdays and rotates between a handful of the Santa Clarita Valley’s financial professionals. His column represents his own views and not necessarily those of The Signal.

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