The 30-year bull market in bonds may be coming to an end. Since 1982, bonds have provided solid returns with significantly less volatility than the stock market. This long-term performance continues to shape investor psychology today.
In fact, after being rocked by the global debt crisis for years, investors frustrated with stock market risk have been moving out of stock investments and into bonds. According to the Investment Company Institute, since 2006, investors have pulled $502 billion from stocks while pouring $1.088 trillion into bonds.
However, with 10-year Treasury yields reaching an all-time low of 1.38 percent on July 25, investors should ask themselves if following the herd is in their long-term best interest since serious risks exist if the bull market in bonds comes to an end. It may be time to examine your bond portfolio to assess how it could be affected by changes in the market.
In order to understand what may cause the tide to turn for bonds, it is important to understand what caused them to rally in the first place. First, there is an inverse relationship between the value of bonds and interest rates. Declining interest rates over the last 30 years have served as a tailwind, pushing bond values higher. However, with interest rates near all-time lows, limited upside potential may exist in government bonds.
While all bonds may not react the same to interest rate fluctuations, a formula that measures the duration of a bond can help determine the sensitivity of your portfolio.
Duration helps investors understand how much their bond portfolio could rise or fall as interest rates change. With a duration of approximately nine years, the 10-year government bond could decline by nearly 9 percent for every 1 percent increase in interest rates. Since interest rates have more room to rise than fall over the immediate term, now is the time to review the duration of your portfolio. Consider visiting www.Morningstar.com to determine your portfolio’s duration.
Despite the uncertainties of our economy, demand for government bonds has remained strong. This has been partly due to investors viewing United States debt as being safer than most alternatives in Europe and the global market.
Bill Gross, manager of the largest bond fund, recently stated that “we are the cleanest dirty shirt” when referring to U.S. debt. While many investors assume that the largest holder of U.S. Treasury is China, the honor is actually held by the Federal Reserve. That’s right — the largest holder of U.S. debt is the U.S.
Through its policy of quantitative easing, the Federal Reserve has kept interest rates artificially low by purchasing government debt.
If and when our economy improves, the Fed may discontinue these purchases, which could ultimately reduce demand and push yields higher. Remember — interest rates up, bond prices down.
In addition, one of the biggest risks to any bond portfolio is inflation. With government bonds yielding a lower rate than the rate of inflation, many investors are realizing negative real returns. While Federal Reserve Chairman Ben Bernanke recently assured lawmakers that the Fed can limit inflation while providing record stimulus, many analysts have their doubts.
The fact is that if the Federal Reserve has to act to limit inflation at some point, interest rate increases may be a cornerstone of its plan.
The headwinds of interest rate increases, lower demand and higher inflation could all combine to form a perfect storm of volatility for government bonds in the future.
Keep in mind that while it may be clear that the bull market in bonds is coming to an end, continued financial stress in Europe may postpone the bear market from coming for some time.
Investors should consider reviewing their portfolio with their adviser to assess risk, discuss goals and determine the most appropriate plan for their unique circumstances before the bear market in bonds arrives.
Kurt J. Rossi, MBA, is a certified financial planner practitioner. He can be reached for questions at (732) 280-7550 and kurt.rossi@Independentwm.com. LPL Financial Member FINRA/SIPC.