Looking for a safe investment? Think twice about bonds -- especially longterm bonds -- with interest rates being as rock-bottom low as they are right now.
Interest rates have nowhere to go but up, and any increase will have a direct and immediate impact on the bond portion of an investor's portfolio. The only question, industry observers say, is how severe the loss in value will be.
It's a question that should interest a lot of investors. From 2009 through the end of 2012, $1 trillion in investment capital flowed into domestic bond funds versus $182 billion flowing out of stock funds, according to DWS Scudder, a Kansas City, Mo.-based fund manager. MorningStar Inc., a provider of independent investment research, reported recently the amount of money that flowed into taxable bond funds in February 2013 topped all other asset classes at $18.6 billion.
If interest rates do rise -- and there's debate on when that might happen -- the impact on investors will depend on how fast and how high rates go, as well as how heavily an individual investor has allocated a portfolio to bonds vs. stocks or other investments.
"I believe it's important investors understand the actual risks associated with a fixed-income portfolio in a rising interest rate environment," said Cameron Short, a senior vice president for Downtown investment firm Stifel.
"We could be near the turning point for what has been a 30-year declining interest rate environment," he said. Three decades ago, he noted, 10-year Treasury bonds yielded about 15 percent. Today that yield is 2 percent.
Bonds, which come in the form of debt issued by corporate or government entities, can protect investors from the wild swings of the stock markets. Interest is generally paid at regular intervals, with rates determined by the quality of the debt and the duration of the bond.
But if a bond is sold before it matures, changes in interest rates will affect how much the investor gets for it. When interest rates rise, bond prices fall.
Bonds with longer maturities pay a higher income to investors, but they also will take a harder fall when rates rise. Shorter dated bonds -- those with maturities of five years or less -- don't pay as much current income, but they won't lose as much either when interest rates inevitably start moving higher.
A very basic way to estimate the potential damage to a bond fund portfolio is to find out the average duration of bonds in the fund. The duration would represent what percentage the portfolio would go down for each 1 percent rise in interest rates.
Hypothetically, an investor with $100,000 invested in a bond mutual fund consisting of 30-year bonds would see the market value of his investment reduced to $70,000 -- a 30 percent drop -- if interest rates were to rise even by 1 percent. A 2 percent rise in rates would increase the damage in that fund to a $60,000 loss.
The same $100,000 invested in a bond fund with a five-year duration would lose only $5,000 if interest rates move up 1 percent, or $10,000 with a 2 percent rate increase.
The reason most people buy 30-year bonds as opposed to five-year bonds almost always comes down to the need for income. The 30-year U.S. Treasury bond currently yields 3.17 percent interest, compared to the five-year Treasury bond, which yields only 0.79 percent. The difference in annual income is $3,170 for the 30-year bond compared to only $790 for the five-year bond.
"A lot of people have been pushing the envelope in their search for higher yields by investing in intermediate-term and long-term bond funds," said P.J. DiNuzzo, president and chief investment officer at DiNuzzo Investment Advisors in Beaver. "Many of them have underestimated the risk to their investment in a rising interest rate environment.
"This is a sleeping time bomb waiting to go off on the bond side of your portfolio," he said. "If you own a bond fund, you want it to average only about two- to three-year duration in this current environment."
But many economists feel rates are not likely to rise anytime soon, especially since the U.S. housing market has not yet fully recovered from the real estate crash of 2008. Rising rates would take home prices lower and cause homebuyers to pay more interest on their mortgage loans.
While there are no apparent signs of rising rates at the moment, Adam Yofan, president of Alpern Wealth Management, Downtown, said it is not a question of 'if" interest rates rise, but "when." He also foresees a scenario where rates could rise higher than most people expect.
"People put their money in bond funds thinking it's a safe investment, especially people who needed income and therefore bought longer duration bond funds. The longer the duration, the more money you could lose when rates go up."
Interest rates have been on a downward spiral for the past seven years.
In June 2006, the Federal Funds rate -- the rate banks pay to borrow money overnight from other banks -- was 5.25 percent. Today it stands at 0.25 percent after the Fed systematically lowered it to stimulate the economy following the financial crisis in 2008.
The Federal Reserve has announced it plans to purchase about $85 billion a month in mortgage-backed securities and Treasury securities as part of a continued attempt to drive down long-term interest rates and encourage more consumer borrowing, spending and investing.
It also would not be in the Fed's own best interest to raise rates too high too fast because its balance sheet would be affected due to the large amount of bonds it owns.
Mr. Short said he does not believe there is enough evidence regarding the strength of the U.S. economy to warrant a rate increase in the near term, but investors need to prepare for an almost certain hike at some point down the road.
"If the Fed raises rates too quickly, it could undo whatever momentum this economy currently has," Mr. Short said. "Although no one can predict the markets with any certainty, I don't expect a major rate increase anytime soon. But I do believe the majority of the bull market in fixed income may be coming to an end."
Tim Grant: email@example.com or 412-263-1591.