Even at historic low rates, bonds have provided a safe haven in the financial markets. But as interest rates have climbed in recent weeks, bond values have started to go down, leaving bondholders unsure about the value of peace of mind.
"There is a bit of mental adjustment that the traditional bond investor needs to process in order to come to grips with the current environment," said Bob Hapanowicz, president of H&A Wealth Advisors, Downtown. "Bonds have been the supersafe trade throughout recent history, and particularly during periods of financial stress, such as what we experienced during 2008 to 2009.
"The danger here is that many of these investors may not have realized that bonds will occasionally deliver negative returns in the short term. This indeed has happened in the first half of 2013, and it has come as a shock to many."
In the five years since the onset of the financial crisis in 2008, investors poured $1.03 trillion into taxable bond and municipal bond funds in a flight to safety, according to Chicago-based Morningstar Inc. But since 2013, the flow of money going into bond funds has slowed to $54 billion. Investors abruptly yanked a record amount of money -- more than $60 billion -- out of bond funds in June as interest rates showed signs of rising.
So far this year, bond funds on average have lost 2.3 percent of their value, according to the Barclays Capital Aggregate Bond Index. Meanwhile, stocks have posted double digit gains in 2013. The Dow Jones industrial average is up 20.11 percent, and the S&P 500 is up 19.57 percent.
"Statistically, many bonds are safer than equities, but as the market is currently handicapping whether the Fed will taper its bond buying, and whether it will raise rates; lately, rates have climbed and bond valuations have dropped," said Mike Maglio, investment director at PNC Wealth Management, Downtown. "Not so for equities. Stock market indexes have risen to all-time highs.
The "30-year bond party, which has been driven by declining rates, appears to be over. So although high-quality bonds are still relatively safe, investors do not want to be overweight in bonds," Mr. Maglio said. "Moreover, investors can lower exposure to the risks of rising rates by reducing average maturity and duration in their fixed income portfolios."
When interest rates go up, the value of existing bonds go down, and vice versa.
Mr. Hapanowicz said bond investors realized 5 percent to 7 percent annual returns in the 10 years ending in December 2012. However, studies have shown that one of the most reliable predictors of future bond performance is the current level of interest rates. On this score, he said, it makes more sense to expect future returns in the 2.5 percent to 3 percent range based on the current yield for the benchmark 10-year Treasury note.
"There is an undeniable current upward bias to interest rates resulting from the strengthening economy and the looming curtailment or end of Federal Reserve quantitative easing, which has had the effect of keeping rates very low," Mr. Hapanowicz said. "As interest rates move higher, bond prices move lower, causing current bondholders to experience principal losses."
Andrei Voicu, chief investment officer at Fragasso Financial Advisors, Downtown, said, "In the longer run, in order to maintain purchasing power and achieve financial objectives, investors need investment portfolios designed to address marketplace realities."
Jay Sommariva, director of fixed income investments at Green Tree-based Fort Pitt Capital Group, said when someone asks him if the bond market is safe in light of rising interest rates, he has to ask them what their idea of safe is.
"In evaluating the risk involved in purchasing a particular bond in a particular sector, 'safe' is a relative word and can be viewed differently depending on your investment strategy and comfort level in market fluctuations," he said. "Conventional risk involved in bond issues includes credit, liquidity and interest rate risk.
"If your goal is to purchase a bond and hold it to maturity, you are still able to get a reasonable coupon and the confidence that principle and interest will be returned in full at maturity. However, be prepared to see some paper losses and market value fluctuations on your bond investment as rates rise to historical normal levels."
Tim Grant: email@example.com or 412-263-1591.