Are Bonds a Risky Bet?

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The stock market has certainly given investors plenty to think about lately. China's turbulence. Sky high valuations. The looming specter of an interest rate hike.

Bonds, on the other hand, have been seen as a relative haven of stability. Yet is that an accurate perception?

Let's find out.

Are bonds riskier than we believe?

Bonds are attractive for several reasons. They provide predictable yields. They typically offer a safe, conservative place to invest money. Yet there is a major development afoot that has introduced an element of risk into the equation.

The math is simple. When interest rates go down, the value of bonds typically rises. If you haven't been living in a cave for the last seven years, you're likely familiar with the effects of qualitative easing. The Fed's policy of pumping out seemingly endless streams of money has acted as powerful stock market stimulant. In a similar vein, low interest rates means great things for bond values -- and rates have been historically low for years. 

So what's the concern?

The looming possibility of an interest rate hike.

The Federal Reserve has been signaling for almost a year that a rate hike is probable in the fall of 2015.  That possibility hit a snag when the Chinese stock market crisis began and global aftershocks ensued. Yet even if rates don't go up in the next month or two, a hike is inevitable. 

Which brings us back to the matter of bonds. How will they react when rates finally climb?

Even the most level-headed investor might be in for a mild shock. Interest rates have been stable for ten years. This has essentially conditioned investors to expect bond values to increase in virtual perpetuity. Even marginally higher rates could have a significantly negative impact.

If you're a pessimist, you might have reason to be concerned that may only be the tip of the iceberg. Bonds have done well for such a long period, there's an outside chance we could be looking at a considerable bubble.

Priority Action Plan

If you're concerned about having too much exposure to bonds, consider the following steps.

  • First, check to see exactly what you're invested in. It's not always straightforward. Some common funds are invested in bonds, but don't make reference to bonds in their name.
  • The easiest way to do this is to check your statement. Read the fine print to see exactly what you're invested in. Most statements are easily accessible online.
  • Be cognizant of liquidity concerns. If the bond market tumbles, buyers may be scarce. This will drive prices even lower. If you're worried about liquidity, consider shorter-term Treasuries.
  • Consider staying on the sidelines until we have more information about any action by the Federal Reserve. Action from the Fed could increase liquidity concerns, particularly as rates gradually increase, so be aware of this if you need to sell.
  • Keep your eye on inflation. It usually means bad news for bonds. An upward trend in inflation -- and rising interest rates -- could provide a major double whammy effect on bond values.

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