The historically low interest rates that the Federal Reserve has been backing as a means of stimulating the economy may be having an unintended side effect: a potential bond bubble that could hurt seniors and others who rely on income from their savings to help pay the bills.
Savers, frustrated by risk-free investments such as bank certificates of deposit paying less than 1 percent, have been taking on more risk with corporate and municipal bonds to make up for lost income.
And while bonds have been relatively stable investments for the past three decades, bond prices have risen so much as interest rates have gone down that there is some concern the bubble could burst.
"Things may change with bonds and we don't know when," said Mike Maglio, investment director at PNC Wealth Management, Downtown.
"I think rates are headed in the other direction, but we don't know when. Many have thought for years rates had to turn around, but they haven't."
Bond prices and bond yields operate like a seesaw. As one goes up, the other goes down. As interest rates rise, bond prices go down and vice versa.
The Federal Reserve announced in June that it intends to keep interest rates at near zero percent through 2014, all but promising to suppress any return that savers can earn at the bank for the foreseeable future. For them, bonds are a tempting alternative.
But a lot of factors could influence interest rates between now and then, including changes in expectations about inflation. If interest rates rise, bonds will lose value.
"If the economy improves, there will be more demand for goods and services," said Mr. Maglio. "Demand for commodities drives prices higher and we could have inflation. If there's going to be inflation, bond buyers will require a higher yield to buy bonds.
"When inflation rises, interest rates rise. If the economy improves, we want to be holding stocks. But if inflation comes along with the improved economy, the value of bonds will go down."
Bonds offer more security than stocks because bonds are essentially loans and the investor is a creditor. The federal government, local municipalities and companies issue bonds to investors with the promise of repaying the initial investment amount, plus interest, over a set period of time.
Investors who plan to hold their bonds to maturity will be less impacted if rates rise. No matter what happens to the market value of the bonds, investors who hold them to maturity will receive all their regular interest payments. When the bond matures, they receive their principal investment back.
Meanwhile, if inflation creeps up higher than the rate that investors receive on the bond, they lose purchasing power over time.
The safest way to invest in bonds is through U.S. Treasury bonds. They are considered risk-free because they are backed by the U.S. government. The trouble is their current yields are so low an investor would need to buy a 30-year bond in order to receive a 2 percent annual return.
Searching for more yield, many investors are taking on more risk buying bonds issued by local governments and corporations.
While there is a higher likelihood of a company or small municipality defaulting, rating agencies help investors determine how secure a bond is. Triple A companies and municipalities (AAA) are the most solid, down to a D, which is bankruptcy. Anything over a triple B minus (BBB-) is considered safe.
There are several other ways to invest in bonds and spread the risk. Bond mutual funds and bond exchange traded funds operate differently than individual bonds issued by companies and governments, but they are just as sensitive to interest rate movements, and their values also would go down if rates were to rise.
"There is no return without risk," said Adam Yofan, president of Alpern Rosenthal Financial Services, Downtown. "Unfortunately these savers and bondholders will either have to buy higher risk investments -- corporate bonds or junk bonds -- or tie up their money for longer periods of time in longer-term Treasuries."
Many seniors have seen their incomes drop dramatically, he said, and it doesn't help that they are now getting around 2 percent on government bonds that used to pay 5 percent.
"At 70 years old, some of them have seen their incomes cut in half, yet their expenses have gone up," Mr. Yofan said. "They have a dilemma -- buy junk bonds [high-yield corporate bonds] or [government] bonds with longer maturities."
Cameron Short, a senior vice president for Stifel Nicolaus, a Downtown investment firm, is seeing more elderly people eager to buy investments yielding higher returns without really understanding how the higher yield is derived.
"When yields are scarce, people tend to reach for yields and may extend themselves to areas they are not familiar with," Mr. Short said. Even though the Federal Reserve has said it will keep rates low for at least another two years, he would still recommend buying only bonds with shorter maturities.
"That's a statement, but not a guarantee," he said of the Federal Reserve. "They can be flexible. If by chance our economy starts to heat up, they can change that time line. The longer term trend is definitely towards higher rates. It has to be. We are starting from ground zero now."businessnews
Tim Grant: email@example.com or 412-263-1591.