If You're a Bond Investor, Beware of the Seesaw
Comment of the Day

July 23 2013

Commentary by David Fuller

If You're a Bond Investor, Beware of the Seesaw

Here is a sample from this important study by the Securities and Exchange Commission, reported by the NYT & IHT (may require subscription registration, a PDF is in the Subscriber's Area)
Lately, though, the S.E.C. has been giving a warning of a different sort. Bearing the general title "Interest Rate Risk," this latest bulletinis a cry for understanding. It's about bonds, and for most people, the subject is confounding.

The problem isn't a new scam but a lack of knowledge about how bonds work, which can be dangerous in a time of rising interest rates. In its bulletin, the agency points out that investors need to understand that when rates rise, bond prices generally fall. This inverse relationship is a fact of life in the bond market. Like gravity in the physical world, it's constant, powerful and important.

But outside trading floors, business schools, banks and brokerage firms, bond dynamics are fairly obscure, surveys find. That's troubling in a time like this, said Lori Schock, director of the agency's Office of Investor Education and Advocacy. "We're not predicting what's going to happen to interest rates or when," she said, "but we do know that rates can't go much lower. And we know that they can go a lot higher."

If interest rates do go higher, most people don't understand how that will affect bonds. A 2012 financial literacy survey by the Finra Investor Education Foundation asked this question: "If interest rates rise, what will typically happen to bond prices?" Prices will fall, but only 28 percent of adult Americans in the survey answered correctly. Finra ran the same survey in 2009 and got the same results.

The Finra survey found that financial literacy levels were generally very low. On its Web site, it offers a five-question quiz, with questions drawn from the survey - none requiring computations, just an understanding of basic concepts. Only 14 percent get them all right, it says. (The average number of correct answers is between 2 and 3.)

As far as bonds go, Ms. Schock said, one way to visualize the relationship of interest rates and prices is to think of what she calls "a teeter-totter." She's from Indiana. In Queens, where I come from, we call it a seesaw. Whatever you call it in your playground, imagine interest rates sitting on one side of a plank and bond prices clinging to the other. When one side rises, the other falls.


It's important right now because interest rates have risen since the spring, and, therefore, prices have fallen. If you don't understand the relationship between prices and rates (often called yields) you could hurt yourself "by reaching for yield, buying bonds that you think are going to pay you more interest, only to see rates go up further, so the value of your bonds will fall," Ms. Schock said.

Many people are in danger of getting hurt this way. "We're concerned that many people might mistakenly think that there's safety in investing in bonds," she said, "when there's actually a fairly good chance of running into trouble with interest rate risk now."

EVEN Treasury bonds are affected by interest rate risk, although the federal government backs these bonds and will pay all the principal and interest if you hold them to maturity. Such high-quality bonds are safe in many ways, especially in comparison with other assets.

David Fuller's view I was briefly surprised that so many US investors who hold bonds appear to be unaware of the risks when interest rates raise… at least until I thought about it. The majority of them were probably highly successful people who succeeded in various careers, and then opted for the lower volatility of bonds relative to shares, plus the fixed yields, when investing their savings during the 30-year plus environment of falling interest rates.

People in a number of other countries will have followed similar policies in their markets. They also benefited from very lengthy secular bull markets in fixed interest investments (Bunds, Gilts, JGBs & Australian bonds). This can dull the senses and cause one to overstay when the fundamentals which drove the bull trend are beginning to change. Even the most experienced and successful investment managers can be susceptible to this problem.

Investors who plan to hold their bonds to maturity may tolerate the swings when rates rise, as the article above points out. However, many of the enormous bond funds are likely to become forced sellers as some holders decide to lower their exposure. This will drive rates up more rapidly than most people expect, as we saw from early May to early July.

Those rises will frighten more investors, tempting some of them to sell. Others, who missed out on the bond bull markets, may be tempted to buy as the secular bear which follows every secular bull develops. There are also some leveraged positions in these markets which will add to the volatility as rates in the US generally rise over the next several years.

Currently, the rally in government bond yields appears to have peaked for the short to potentially medium term, and is likely to pull back in a reaction and consolidation phase. Mr Bernanke and his successor will try to delay or at least slow the rise in yields, and he should have some success in this respect. If so, that will present another opportunity to reduce exposure in the fixed interest markets, for those who do not wish to hold their positions to maturity. However, it is very unlikely that yields will retest their lows, as that would require a significant deterioration in the global economy from current levels. It is an uncertain world but that seems unlikely, based on what we know today.

The period of maximum risk for investors in long-dated bonds will occur after quantitative easing (QE) and its variations in Europe and Japan are phased out, and both GDP growth and inflation are rising.

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