Considering Bonds? Keep an Eye on Interest Rates

A low appetite for risk and lingering uncertainty about the health of the stock market has many consumers weighing the pros and cons of bonds and other fixed income investments. If you’re looking to invest in these steady return options, here are a few things you should keep in mind.

Bonds vs. Stocks

Under normal economic conditions, stocks tend to outperform bonds over long periods of time. Contrarily, bonds are fixed; barring a default or other unusual event, bond investors receive their principal plus the assigned interest at the time of maturation.

Exceptions to the rule exist. In periods of severe economic volatility, bond interest rates can yield higher returns than stocks. Until the stock market began to rally in the second half of 2009, the decade prior generally proved more favorable to bonds than stocks. This fact, coupled with a sense of uncertainty about the market, has driven some investors to recalibrate their portfolios’ bonds to stocks ratio.

Will bonds continue to generate higher returns going forward? Nobody can say for certain, but the low interest rate environment may be an obstacle that stands in the way of superior bond market performance in the years to come.

Interest rates and prices–an inverse relationship

An important fact to keep in mind is that bond prices are affected by the direction of interest rates. When interest rates decline, bonds increase in price. When interest rates rise, bond prices fall. Returns for bondholders typically rise in an environment where interest rates are declining, a trend that has worked to the benefit of bond investors in the past decade.

Why do interest rates affect bond prices? Consider this simplified example: Suppose you invest in a bond from an issuer for $1,000 and it pays 4 percent interest. If, one month later, the same issuer offers a $1,000 bond with a 5 percent interest rate, you could buy the same bond and receive an annual income of $50. In that case, the original bond you purchased that pays only $40 in income is no longer worth $1,000. To match the current market yield of 5 percent, a buyer would only offer $800 for your older bond to achieve a comparable yield based on the $40 annual income payout.

Of course, if you hold the bond until it matures, the issuer is obligated to repay the entire face value of the bond, in this example, $1,000. Then again, if you wish to sell it in the secondary market prior to maturity, the bond has lost value (unless the interest rate environment has changed enough in your favor to compensate.)

Today’s low interest rate environment

Keeping in mind how interest rate movements affect bonds, consider the state of interest rates in today’s market. They are at relatively low levels on an historic basis.

For example, one of the benchmark measures of the bond market, the 10-year U.S. Treasury note, had a yield of 3.4 percent (as of October 30, 2009). The yield on the 10-year Treasury note has rarely dipped under 3 percent and typically is much higher. In fact, in the fall of 1981, 10-year Treasury note yields soared above 15 percent. The note of caution for investors is that long-term interest rates may not have much room to decline from current levels, limiting the potential upside for bond values.

The greater risk in the current environment is that interest rates will rise, depressing values of existing bonds. If that occurs, it could have a detrimental impact on your bond portfolio.

Historically, interest rates have tended to move higher in periods of economic recovery. This is important to bear in mind as you consider putting your money in bonds. If the economy continues to build steam, you may need to temper your expectations about future returns on your fixed-income portfolio.

AJ Jugan and Brian Stumpf are financial advisors and Certified Financial Planner™ professionals. Andrew (AJ) can be reached by calling 412-635-5813 or emailing andrew.m.jugan@ampf.com. Brian can be reached by calling 724-799-2782 or emailing brian.d.stumpf@ampf.com.