Low and near-zero interest rates have become a fact of life. Rates could likely remain low for the foreseeable future based on the economic and US Federal Reserve environment. This statement is not meant to be a predictor of where interest rates are going. Still, the fact of near-zero interest rates needs to be on investors’ radar screens, as boring as the topic may sound!
The bond market and interest rates involve far, far more complicated math than stocks. Trying to predict bond prices and interest rates is mostly not worthwhile.
With this said, bonds remain a critical part of an investor’s portfolio, more so for those closer to retirement but also for younger working people in the short-, intermediate- and long-term. Why?
- Bonds, specifically short-term bonds (say, between 1-3 years), offer price stability in a portfolio.
- Price stability indicates lower risk. (Defined by Standard Deviation.)
- Often this price stability comes with low or near-zero yield or interest.
- Volatility in portfolios is not going away; therefore, components that reduce volatility are necessary – particularly in or near retirement.
- Note that stocks increase volatility, although the growth potential of stocks in effect pays the investor for taking that risk.
- Bonds at most basic do not contain a growth component. Bonds are designed to pay a stream of income and then pay the bond owner back principal when the bond matures.
- Bonds, in particular short-term bonds, can be used as a source of income or a “safe haven” for withdrawals in times of stock declines.
Talking about bonds can be super-boring… but necessary. You may be asking yourself, “Why would I want to invest in bonds?” At most basic, the answer is because cash yields zero in most cases these days, although remember that cash for certain shorter-term, defined goals is still KING. And, looking out further in time, constructing a strategy around bonds and certain kinds of bonds can add at least a small amount of income plus act as a “balance factor” in a well-designed portfolio.
A few more facts about bonds:
- Bond prices can swing widely, particularly bonds with medium- and long-term maturities. Although medium- and long-term bonds typically pay higher rates of interest.
- With all of the recent Federal Reserve stimulus, bond prices have been almost artificially supported. Look out for this to change in the future!
- When interest rates go UP, bond PRICES GO DOWN (there is complex math behind this fact).
- With interest rates near zero, there is a fair amount of risk in the prices of today’s bonds; therefore, diversifying within the bond asset class is necessary.
- Income from bonds complements stock dividends in a portfolio.
- Investors need to know exactly what kinds of bonds they own (especially, in a 401k account).
- Inflation is an enemy of bonds but can be partly managed.
- Inflation expectations (inflation is a fact of life) figure in to the bond investing landscape….
- …. And certain types of US Treasury bonds, called TIPS or Treasury Inflation Protected bonds, can take advantage of inflation – kind of counter-intuitive.
Bonds still matter. Total return matters. Investing in a near-zero interest rate environment requires a strategy.(Note, there are negative interest rates in several European countries and Japan today.) Bonds, particularly short-term bonds, can be a lifesaver in volatile stock markets and this fact is why the topic is worth discussing.
Thank you for reading, stay safe, stay “steady” and TGIF!