There has been a lot of talk in the press recently about bonds (just two recent examples – one in the Wall Street Journal and one in the Boston Globe). Most if not all of the articles make the following argument:
- Interest rates are at historic lows.
- Therefore, interest rates must
- Rise;
- Rise soon;
- Rise a lot.
- When interest rates rise, bond prices fall.
- Investors who hold bond mutual funds are doomed to take big losses as interest rates fall.
- Therefore, investors should sell their bond mutual funds and (choose one or more of):
- Hold cash until interest rates rise, and then buy bonds;
- Buy bond funds with higher interest rates, which won’t fall as much in price when interest rates rise;
- Invest in “low risk” stocks that pay high dividends.
Statements 1) and 3) are absolutely true. Interest rates are quite low, and when interest rates rise, bond prices fall. In fact, interest rates are lower than they have been at least since the early 1960s.
However, 2), 4) and 5) do not necessarily follow.
Interest Rates Are Unpredictable
Like stock prices, interest rates are unpredictable. Here’s an example to illustrate the difficulty. Bill Gross manages the PIMCO Total Return Fund, the largest mutual fund in the United States. He is widely recognized as a bond expert. He is a “goto” expert for the financial press on the subject of bonds and interest rates. In 2011, he predicted that interest rates would rise. He was sure enough of his prediction that he bet against Treasury bonds in that fund. Unfortunately, rates fell further. The fund returned 3.5% less than its benchmark, and ranked in the bottom 15% of comparable funds for the year.
While interest rates are low today, they could still go lower. Rates in Switzerland and Japan are lower than US rates. The most recent changes in interest rates in most countries have been declines. That does not mean that US rates will fall further, but they could.
I happen to think that ten years from now rates will be higher than they are now. Unfortunately, I know of no credible predictions about when the increase will start, how high rates will go, and how fast they will get there. And, while I believe it to be very likely, I am not absolutely certain.
When and how fast and how far rates will rise all matter a lot in deciding what to do. If you knew those three things, you could maximize your return. If rates were going to rise fast, you’d sell all of your bonds just before the rise started, and buy new ones just after it stopped. That way, you’d sell your bonds just before prices started to fall (selling high), and buy them just after they stopped falling (buying low). On the other hand, if you knew rates would rise slowly, you’d just hold on – the extra interest you’d earn from holding the bonds rather than cash would offset the loss from holding the bonds.
Maximizing Return
The focus in the press is precisely on that question: how to maximize return. That question is not very helpful for two reasons.
First, maximizing return is impossible in a world where returns are unpredictable. People (want to) think that they can do it. The evidence is that when people try to maximize return by buying or selling, they make a lot of mistakes, and actually get lower returns on average than they would have without doing any trading.
Second, and more importantly, trying to maximize return distracts you from your primary goals: paying for college, enjoying a secure retirement, and so on. A lot of your financial effort focuses on preparing to make future payments – especially college tuition and spending in retirement (after your earned income has stopped).
It is useful to think of those planned future payments as liabilities, entries on the liability side of your lifetime balance sheet.
Your lifetime balance sheet is a snapshot of your overall financial position today. Your human capital (your earning power), your house, and your financial holdings are your major assets. Your mortgage, student loans, credit card debt; anything else you owe, and the present value of spending you plan to do in the future make up the liability side. You use the present value of planned future payments because that tells you how much money you need today to be able to make those payments in the future.
If your liabilities exceed your assets, you won’t be able to afford everything you plan to do. On the other hand, if your assets exceed your liabilities, you have a surplus on your lifetime balance sheet. Then you can do more – leave more to your heirs, give more to charity, spend more on college or in retirement, and so on.
When you focus solely on returns, especially on bond prices, you are focusing on assets alone, and ignoring your liabilities. That matters because the value of your liabilities, especially the present value of those planned future payments, depends on the interest rate just as bond prices do.
The Ideal Bond Portfolio
The ideal bond portfolio matches individual bonds with planned future payments. This arrangement “immunizes” your balance sheet from interest rate fluctuations. That is, the values of your bond holdings and your planned future payments will change by exactly the same amounts when interest rates rise. However, very few if any people have this sort of portfolio. For any other bond portfolio, increasing interest rates will have a positive or negative impact on your financial situation.
Roughly speaking, if you plan to make your future payments after your bonds mature, a rise in interest rates will reduce the present value of your future payments more than the value of your bonds. The surplus on your lifetime balance sheet will grow, even if the value of your bonds falls quite a bit, and you will be better off.
As a practical matter, there are two situations where you might wish to adjust the average maturity of your bond holdings:
- If your child is close to starting college, and your 529 is invested entirely in a TIPS fund, you might shift some or all of the 529 holdings to bond funds with shorter average maturities.
- If you are well into retirement, again you might wish to shift some of your holdings into bond funds with shorter average maturities.
As a final note, if interest rates do rise rapidly in the next few years, some bond fund prices may decline rather sharply. While you may be intellectually convinced that you are better off because your liabilities have fallen even more, you may still find the negative numbers on your brokerage statement distressing.
If you think this might be true for you, or if you have any other concerns about the bond holdings in your portfolio, please contact us. We’ll be happy to work through the issues with you.