Everyone knows that a well-diversified portfolio should contain bonds. Bonds typically provide stability and keep portfolios safe, especially when the market is tanking. But sometimes, that last statement couldn't be further from the truth.
Here are three reasons why you should be leery of the current bond market:
Interest rates are at historic lows. As of a result of Federal Reserve policy over the last few years, lending and borrowing costs have fallen to historic lows, but so has the return on your money. While this may look good to a borrower, bond investors beware.
Think of it this way. If you buy a corporate bond today, your yield will be about 1 percent per year if you invest for the short term. The only way to get a better payoff is to hold the bond for a longer period of time. A 10-year corporate bond will give you a yield closer to 4 percent. While that's four times as much, it is an abysmal rate when you think about outpacing inflation and taxes.
To put it in real terms, if you invest $10,000 and you get 1 percent, your return is only $100. If you get 4 percent, that's only $400. Why bother?
You must purchase a longer term bond. In order to get a higher return of 4 percent instead of 1 percent, you must hold the bond longer. And that may be fine for the shorter term as you'll be getting 4 percent, while everyone else is only earning 1 percent. The real issue comes over the longer term. Let's assume interest rates go up in the next few years: Three years from now that same bond could be paying 7 percent. Now other investors are getting 7 percent, while you are still only getting 4 percent. They are making almost twice your rate.
As interest rates go up, bond prices go down. The third reason for being cautious when investing in bonds today concerns your bond's value. Based on the situation described above where you are getting a 4 percent rate while new bond purchasers (of the same bond) are able to earn 7 percent, you now decide to sell your bond. The issue here is that your bond will have decreased in value based on current pricing. The easiest way to think of this is if your bond is paying 4 percent, but I can buy the same bond that now pays 7 percent, yours is not worth as much to me. I may still offer to buy it, but at a much lower rate. Now you understand the inverse relation between interest rates and bond prices.
Bonds are a little scary now, simply because of what is happening with interest rates. As the market continues to improve, rates will go up and bond values, well, you know where they will go—down. Be careful where you look for safety.
Good luck and happy investing.
Kelly Campbell , Certified Financial Planner and Accredited Investment Fiduciary, is founder of Campbell Wealth Management, a Registered Investment Advisor in Fairfax, Va. Campbell is also the author of Fire Your Broker, a controversial look at the broker industry written as an empathetic response to the trials and tribulations many investors have faced as the stock market cratered and their advisers abandoned their responsibilities to help them weather the storm.