Last month I spoke to a group of about 180 investors in the Seattle area, and it quickly became clear that one of their biggest concerns was bonds — specifically, what might happen to bonds if interest rates rise.
During my talk, I asked for a show of hands from those who were afraid to invest in bonds. Most hands went up. Then I asked who was afraid to invest in stocks. Only two hands were raised.
“How can you suggest I put money into bonds when you know they’re going to go down?” one woman asked.
It’s a reasonable question. By that logic, however, I should never suggest that anyone invest in equities. In fact, I often remind people that if they invest in equity funds, they are virtually guaranteed to lose money at some point.
“I think bonds are riskier than stocks,” another investor said.
It was startling to realize that only about one in 100 of these relatively knowledgeable investors were worried about the very real possibility that their stock holdings could decline by 50%, while most were anxious about a possible 5% decline in their bonds.
Yes, interest rates are a legitimate concern. Many Americans believe rates must eventually rise. And as most people know, rising interest rates generally mean falling prices for existing bonds.
But does the prospect of higher rates necessarily spell trouble for bond investors? I don’t think so.
If I were talking to investors whose goal was to buy low and sell high, their concern would make sense. With interest rates low, bond prices are relatively high, which could make this a reasonable time to sell bonds for a profit.
But most investors don’t own bonds for that reason. They own bonds to stabilize their portfolios and reduce the risk that comes with owning stocks.
If you want bonds to protect you when stocks decline, the only way to get that protection is to hold on to those bonds.
I agree with the consensus that interest rates will likely rise someday. That has been the prevailing view for much of the past 20 years. But no one knows when rates will rise, how far they will rise, or how quickly they will rise.
So why is fear of bonds so widespread?
One reason may be that bonds appear simple. There are only two variables to track: interest rates and prices. Stocks, by contrast, are influenced by hundreds of factors, making them far more complex — and harder for the human mind to process.
The easiest factor to grasp is recent performance. Stocks have been rising since March 2009, creating what I believe is a false sense of confidence and dulling memories of the pain caused by past bear markets.
Another reason for the fear of bonds was articulated well by my friend Dennis Tilley, chief investment officer at Merriman. (I founded the firm in 1983 but am no longer affiliated with it except as a client.)
For more than 15 years, I have relied on Dennis’s research for much of my own portfolio. I believe he is exactly right.
In an article earlier this year, Dennis wrote that the financial media has blown the bond story far out of proportion, using inflammatory headlines to grab attention.
Phrases like “the coming bloodbath for bondholders” or “the imminent bursting of the bond bubble” are designed to scare investors. At best, they are misleading. At worst, they are cynical attempts to sell newsletters and special insights.
What many investors fail to understand is that rising interest rates can actually benefit shareholders in money-market funds and short- to intermediate-term bond funds. As bonds mature, the proceeds are reinvested at higher rates, increasing income over time.
Many years ago, Dennis Tilley and I — along with our research team — studied which fixed-income investments best stabilize an equity portfolio during bear markets.
We concluded that the best choice in tax-deferred or tax-free accounts is a combination of TIPS funds and short- to intermediate-term U.S. government bonds. In taxable accounts, municipal bonds are sometimes preferable.
As Dennis noted, U.S. government bonds and municipal bonds have historically delivered after-tax returns above inflation and have low correlation with stocks. That means they often rise when equities fall.
In my own portfolio, the effective duration of my bond holdings is about four to five years. That means a one-percentage-point rise in interest rates would be expected to reduce their value by roughly 5%.
Some investors ask why they should own bonds at all if bond prices fall while stock prices rise.
The answer is simple. If I knew in advance that bond prices were going down and stocks were going up, I would certainly adjust my portfolio. But neither I nor anyone else has that kind of foresight.
Dennis offers three common-sense reasons investors should stop worrying about rising rates.
First, expert consensus is often wrong. When everyone believes something is inevitable, that belief is already reflected in market prices.
Second, a bond portfolio duration of four to five years appears to be a sweet spot. It has historically provided returns above inflation while helping to offset stock market losses, and it adapts relatively quickly to rising rates.
Third, for investors who own both stocks and bonds, rising interest rates often coincide with an improving economy. In such environments, bonds may experience modest losses while stocks enjoy strong gains.
This is how diversification works. One asset class declines while another rises, partially or fully offsetting the loss.
For these reasons, I believe the current fear of bonds is misplaced.
If you care about your long-term financial success, I have three simple suggestions.
First, keep your emotions in check. Second, ignore inflammatory media headlines and resist the herd mentality. Third, establish a sensible long-term balance between stocks and bonds — and stick with it.
Richard Buck contributed to this article.