But bond investors are facing two challenges today: the threat of falling prices and extremely low yields. How can you protect against falling prices and where can you reinvest to earn a decent yield?
Why are prices expected to fall? As yields rise, prices fall. A simple example will explain.
Investor Bob purchases a 20-year $1,000 bond with a yield of 4%. Next year, interest rates rise to 6%. Anyone in the market for bonds can now buy one with a 6% yield. Why would anyone buy Bob's bond at a 4% yield if they can earn 6% on another one? They wouldn't, so Bob will have to lower his price so it yields 6% to the buyer. Hence the drop in value.
Conversely, if interest rates fall, prices rise, which is what happened from 1981 to 2012. I won't bore you with the mathematical calculations, but if you really want to discuss bond math then send me an email.
The chart shows how 20-year government bonds fell in price after World War II and then started rising in the early 1980s when interest rates were at record highs. In 1981 you could lock in a very high yield while enjoying a steady price rise. But the bond strategies that worked for 31 years aren't going to be successful in the future. Bond strategies that work when rates are falling don't work in a rising rate environment.
By the way, don't confuse the yield of the bond to its coupon rate. I've heard people say, "I can buy a GE bond that pays a 6% coupon." But the coupon rate is calculated at a par value of $1,000, and bonds don't sell at par value in the open market. They sell at a discount or a premium depending on current market rates. In today's low-rate environment, a 6% coupon bond will sell for more than its par value, driving down its "yield-to-maturity," commonly referred to as its yield. Always ask what a bond's yield is, not the coupon rate when buying bonds. Salespeople make a lot of money selling bonds to uneducated buyers.
So what should you do?
First, if you bought your bonds at a decent yield, don't sell them unless the issuer has financial problems. With today's yields so low you want to hold them to maturity. Holding to maturity will lock in your original yield.
Second, when your bonds mature and you reinvest, limit the duration. Shorter term bonds don't drop as much as longer term bonds when rates rise. Also, in a rising rate environment, you want your bonds to mature quicker so that you can reinvest them at the higher rates.
Where can you find higher yields?
One of the most oft-asked questions today is "Where can I find an investment with better yields than the paltry amount in CDs?" Some investors are "reaching for yield." Because rates are so low, they're looking wherever they can for higher yields, but they may be blindly increasing their portfolio risk without knowing it.
In my next article, I'll discuss places and ways to find higher yields, such as business development corporations (BDC's), closed-end funds, high-yield bonds and dividend-paying stocks. I'll also discuss some of the risks with each of them.
Gary E.D. Alt is an Accredited Investment Fiduciary with Monterey Private Wealth in Pleasanton. Send questions to firstname.lastname@example.org.