How Bond Investors Stand to Lose When Interest Rates Rise

— -- In a key scene in the movie “Wall Street,” when Charlie Sheen’s character is about to be arrested for securities fraud, the seasoned investment pro played by Hal Holbrook likens Sheen’s impending doom to a man “looking into the abyss.” Many bond investors may be looking into their own kind of abyss in the coming months and years, as current low yields rise.

Of course, “Wall Street” was all about the stock market. In some ways, the dynamics of bonds are the opposite. Increases in the yields of new bonds hurt holders of existing bonds.

“Wall Street” was released in 1987, the year that the intense bull market that inspired the film crashed. At that time, a long bull market in bonds was already under way because yields on bonds, which had peaked at nearly 16 percent in 1982, were on the way down to their nadir last year of less than 2 percent.

When yields (the interest rates paid) on new bonds are decreasing, the market value of existing bonds, issued at higher rates, rises. Because of bond market volatility from the emerging risk scenario and a diminishing number of buyers, rates paid on new bonds have started to rise. Since April, the rate on the 10-year Treasury bond (considered a marker for bond rates in general) has popped up more than 1 percentage point. This tamps down the value of existing bonds, both government bonds and those issued by corporations, paying lower rates.

The combined effect of trillions of dollars in bonds paying low rates and yields on new bonds rising can be hard to fathom. Few people can remember an unfavorable bond market. People would have to have been trading bonds for 35 or 40 years to remember a bond market that wasn’t a flat-out, running bull.

Most investors have been lulled into a false sense of security concerning bonds because all they’ve known is upside with low risk. Somewhere on Wall Street, there may be a few old guys making dire, Holbrookesque pronouncements about the coming bond abyss. But few are listening to them. Instead, people who never knew another type of bond market continue to pour money into new bonds, spurring demand and propelling rates further upward, increasing their own risk.

Yet money continues to pour into bonds. In the first quarter of this year, net cash inflows into bond funds totaled $102 billion, according to according to a Bank of America report. That’s the greatest inflow since 2001.

If you have a 30-year bond that pays the April rate of about 2 percent annually, and new bonds are being issued at 3, then 4, then 5 percent, this depresses the value of your bond if you’d go to sell it. Why should anyone buy your bond at face value to get 2 percent when they can a higher rate with a new bond? If you decide to keep your bond until maturity, you run the risk that rising inflation will eat away at the buying power of the money in your investment. As inflation rises, every dollar you own buys fewer goods and services.

And inflation, which has been less than 1 percent since 2014 and is now around 0, seems likely to rise. If it rises enough while your Jurassic dollars are trapped in bond amber, their ultimate buying power will diminish without enough income from the bond. This defeats your purpose in buying the bond in the first place.

This scenario is bad enough for institutional investors. For individuals, it gets worse because if they want to unload low-yield corporate or municipal bonds, they bring significantly lower prices than those commanded by institutions, which have the advantage of volume.

Shareholders in bond mutual funds have an easier time because the price changes to the underlying bonds are factored in at the end of each day. But still, there’s no place to hide from bond price changes. Even bond funds with shorter maturities will drop in value when interest rates rise. In general, funds invested in longer-term bonds will drop the most.

To protect your portfolio, consider these moves:

• Limit maturities on new bond purchases – or in bond funds-- to five years, especially on corporate bonds. As bonds with longer maturities pay higher rates for the uncertainty involved, you’ll receive less yield, but you’ll reduce your risk and the angst that goes along with it.
• On the longer-term bonds you own -- especially those with maturities of 20 or 30 years, consider selling now and taking the best price you can get for them, within reason.
• As one new home for your long bond money, look at high-quality stocks. There has never been a 15-year stretch where stock market averages lost money, even in the eras of the Great Depression and the Great Recession. One easy way to put long bond money into the stock market equivalent of secure bond investments is to buy dividend-paying stocks. Stocks that consistently pay dividends -- which tend to be mature, blue chip companies -- have secure, bond-like characteristics, as the dividend income is pretty reliable (and can be regularly reinvested), and this advantage supports demand and buoys price. Yet unlike bonds, you’re income from them isn’t fixed. If the stock price is rising, stockholders get better earnings and probably higher dividends. An easy way to buy dividend-payers is through targeted exchange-traded funds (ETFs), which are currently returning upwards of 3 percent, compared with the 2 percent yield of many bond funds.
• Closed-end funds. These are bond funds that trade like a stock on exchanges. They are actively managed, meaning that investment managers buy and sell bonds owned by the fund. They are called closed because, unlike open-ended (regular bond mutual funds), they raise money in one fell swoop and then invest it, rather than taking constant inflows of investor money. With closed-end funds, you can’t sell shares back to the fund as you can with regular funds. The only way to unload them is to sell them to another investor on a stock exchange. The idea is to get these shares at a discount, and you can only do this by avoiding new issues, instead waiting until the shares begin trading at a discount. Using www.cefa.com, you can screen and sort closed-end funds by style and strategy. Unlike managers of regular funds, managers of closed-end funds don’t have to keep cash on hand to pay redemptions, so they don’t have pressure to sell holdings. Freedom from such concerns enables them to achieve higher net returns – for shareholders who buy at a discount on the open market. Disadvantages of closed-end funds include generally high expenses and a vulnerability to departures of marquee managers, which can hurt share price.

Whatever you do, don’t manage your portfolio with the long-entrenched belief that bonds are low-risk investments or subscribe to the now-obsolete strategy of allocating an increasing percentage of your assets to bonds as you approach retirement. And purchasing long bonds now could be an eventual buying-power nightmare for those who are retiring soon. If instead you gird your portfolio against risk by reducing your bond investments and avoiding long bonds altogether, you can dodge much of the damage that the old guys are warning about.

Any opinions expressed in this column are solely those of the author.

Dave Sheaff Gilreath is a founding principal of Sheaff Brock Investment Advisors LLC. He has more than 30 years of experience in the financial services industry, beginning with Bache Halsey Stuart Shields and later Morgan Stanley Dean Witter. At Sheaff Brock, he shares responsibility for setting investment policy, asset allocation and security selection for the company's managed accounts. He also consults with the clients on portfolio construction. Gilreath received his Certified Financial Planner® (CFP) designation in 1984. He attended Miami University in Oxford, Ohio, where he earned a B.S. degree.