Approach Bonds With Caution

Even though the debt reduction deal reached just before the deadline prevented the United States from defaulting on its national debt, the crisis isn’t really over. There are still a lot of uncertainties going  forward. During uncertain times, investors often run towards the safest investments they can find.  Historically, that safe haven has been government issued Treasury securities but with those now standing on shaky ground investors are looking for the next best thing.  Many will take a long look at corporate and other short-term instruments.  That could be a mistake.

When there is turmoil in the markets or in the economy, people naturally tend towards conservative investments.  They look for investments that fluctuate relatively little in value and can pay a steady income while in the process waiting out any turmoil in the market.  But bonds and bond funds don’t necessarily appear to be that conservative right now.

National debt

Take into account where bonds and bond funds currently sit from a value perspective right now.  Interest rates continue to hover near all time low levels and there’s not much room left for them to drop even in ideal economic conditions.  In the current environment though, there are several events on the horizon that could push rates higher in the near term.

The first is the huge amount of government debt.  Even before the drop dead date for Congress to come to a resolution, the perception in the markets is that United States government debt is starting to become riskier.  It’s still rated AAA but there’s the threat of a downgrade even as the default has been avoided and the huge federal debt number can’t be ignored.  As the risk of government debt rises, the interest rate that the government needs to pay on that debt will rise as well.  Rising rates make existing debt with lower rates on it less valuable which is not good news for bond investors.

The second is an economic recovery.  Given that the economy has been struggling for almost three years now, that possibility seems more like a sparkle on the horizon instead of a legitimate prospect but it’s going to happen sooner or later.  When the economy starts picking up and unemployment returns to more normal levels, we’re going to see rates start rising to a historically more normal level.  That rise in rates will hurt bond prices too.

The only scenario in which rates will continue to remain low is if there is continued economic weakness.  In that case, the Fed will likely keep rates low in order to stimulate activity and get things going again.  But bond prices rise when rates go down and considering that rates are already at historically low levels there doesn’t appear to be much upside remaining.

Bonds should always retain a place in your portfolio as an investment that can help hedge and offset the risk that comes with other riskier investments like stocks.  But if you’re looking to switch money from stocks over to bonds thinking that it’ll be safer there and you’ll have a better chance at a solid return, you need to be cautious.  There are several pieces of evidence to suggest that bonds might not be the safe haven you’d expect given the current market conditions.

If you’re considering an investment in bonds right now, it’d be best to temper your expectations and approach with caution.

Photo credit: aar0on

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Author Info

This post was written by David Dierking. David lives outside Milwaukee, Wisconsin and has been working in the financial services industry for over 13 years with a background in investments, accounting, and marketing. He earned his Chartered Financial Analyst designation from the CFA Institute in 2004 and was recently published in the Milwaukee Business Journal. You can also check him out at The Ultimate Fit Challenge

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