With the daily, and in some cases hourly, reports of the Dow Jones, S&P 500 and NASDAQ prices, it’s no wonder that the stock market is the first thing that comes to mind when most people think of investing. Compared to the hype and borderline hysteria often associated with the stock market, the lesser-reported bond market can seem dull and less significant.
But a bit like the tortoise in “The Tortoise and the Hare,” slow and steady performing bonds have offered a level of security that’s been difficult to match over the last 15 years. As a result, they’re often considered and used as a hedge against stock market risk. But let me back up and explain how they work and why they perform differently.
In the simplest terms, bonds are essentially a loan you make to the government (i.e Treasury bonds) or a corporation. Like a traditional loan, bonds have both a term ranging from a few days to many years, and an interest rate attached to them. Here’s where bonds get interesting.
There is an inverse relationship between bond prices and interest rates. In fact, the bond market actually dictates what lenders charge for loans, including car loans, home equity accounts, and even mortgages.
In 2008 the Federal Reserve attempted to stimulate the economy by buying bonds and artificially keeping interest rates low. However, the Federal Reserve recently put Wall Street on notice that the monthly $85 billion bond buying spree will end some day soon. That has helped push the yield on the US 10-Year Treasury Note to approximately 2.1 percent. That’s a significant increase from the less-than-1.5 percent yield experienced at the same time last year.
Together, those factors make this an excellent time to review bond holdings.
One strategy to mitigate bond price decreases in the face of higher interest rates is to find bonds that are less interest sensitive. Examples of these include High-Yield and Floating Rate bonds. In addition, consider very short-term bonds (i.e. two years or less), as their value tends to fluctuate less than longer-term bonds.
If you have a 401k and own bond funds, review your choices and find out how interest sensitive they are. Further, ask if your plan offers Stable Funds or money market funds that don’t fluctuate in value.
Just like a road race, investing requires preparation. You need to research and determine your course, you need to identify potential risks and you need to develop a plan for addressing the ups and downs you may face along the way. While preparation is no guarantee that you’ll emerge the ultimate winner, it greatly improves your chances of finishing exactly where you deserve.