By Drew O’Neil
March 12, 2018
An all too common conversation that I find myself having with advisors revolves around the general theme of investors who say: “I don’t want to invest in bonds right now because rates are about to rise and I don’t want to lose money.” My response focuses on a couple of points that are important to understand. The first is the issue that I have with the statement “rates are about to rise”, and how it is stated as a given, inevitable fact. The second part of the statement that needs to be addressed is the idea that a bond investor will lose money when interest rates rise.
Let’s address the “rates are about to rise” issue first. The certainty that this statement is made is where the problem lies. Could rates be at the start of a trend higher? Sure. Could rates remain range-bound and essentially move sideways for the foreseeable future? Yep. Could rates start moving lower next week and remain there for the new few years? Of course. The point here is that no one knows where rates will be next week, much less next month or next year. Just because headlines are proclaiming that rates are heading higher and experts are predicting higher yields, does not make it a certainty. To highlight this point, take a look at the chart below, which highlights that these predictions are nothing new and are actually an annual occurrence. This chart highlights the consensus prediction (red lines) at the beginning of each year going back to 2008 for what the 10-year Treasury will do over the next 5 quarters taken via survey by the Federal Reserve Bank of Philadelphia. The blue line is what 10-year Treasury yields actually did.
(Sources: Philadelphia Fed, Bloomberg LP, Raymond James)
As you can see, almost like clockwork, at the start of each year experts forecast that rates are about to rise. Looking at the 10 years from 2008 thru 2017, they have been right twice (20% of the time). My point is not to knock these experts, but to highlight that predicting the future is very hard to do. Basing your financial planning on the predictions of a group of people that are essentially only correct 20% of the time might be more risk than you should take with your financial future.
Now for the “I will lose money if I invest now and interest rates rise” comment. The misunderstanding stems from considering only the change in the market price of a bond when rates rise. A better understanding of how bonds work considers, for example, if I buy a bond that matures in 5 years at a yield of 3%, there are essentially only two ways that I can lose money on my investment:
I choose to sell the bond at a loss prior to the bond maturing. This decision is entirely up to me. If I buy the bond and interest rates start to rise therefore lowering the price of my bond below the price I paid for it, I have two options: a) I can choose to sell the bond at a loss and “lock-in” the loss, or b) I can choose to hold the bond until maturity and earn my 3% annual return on the position.
The bond defaults, which if I am buying high-quality bonds, there is a very low likelihood of this happening.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.