In mid-May, a quick review of the Wall Street Journal revealed the average yield on a five-year CD was 1.26% and the ten-year US Treasury note was yielding 1.85%.
These low rates can lead investors to seek higher returns in other places. Two especially popular ones are longer-term bonds and high-yield bonds. While there may be a place for these in your portfolio, the age old warning, “caveat emptor” or buyer beware, bears repeating, and here’s why.
As investors, we all want higher returns, but we also want less risk. How you balance your pursuit of these preferences will go a long way towards achieving your unique definition of a successful investing experience.
If the purpose of bonds in your portfolio is primarily to provide stability and reducing risk; high-quality, short-term bonds make the most sense. However, as mentioned above, currently these bonds provide small returns. There are other kinds of bonds with higher current interest rates, including very long-term bonds and lower quality, “high-yield” (aka “junk”) bonds. Both are also higher risk in terms of potential price variation prior to maturity.
Bond prices move in the opposite direction of interest rates. So, if the Federal Reserve does influence a rise in interest rates (someday!), the price of an investor’s bonds, all other things being equal, will decline. The longer term the bond, the greater the price variation. A graphic in the Wall Street Journal on May 19, 2016, illustrated the potential price declines of high-quality government bonds of differing maturities. The graphic reveals how a 1% increase in interest rates, causes the price of a US 10-year Treasury bond to decline by 9%, while the price of a French 50-year bond would by 27%. The effective annual yield of the French 50-year bond is currently under 3.25%. Is an additional 1.25% in current yield worth the increased risk of an 18% price decline (or more if rates rise by more than 1%) in the next 10 to 20 years?
Bond investors also reach for higher yield by purchasing lower quality bonds. Bond buyers set the actual market price and yields on bonds with similar maturity dates according to credit quality (the likelihood the issuer will make interest payments and repay in full on time). The higher the probability of default or late or restructured payments, the higher the interest rate demanded by bond buyers. While investors may get a higher initial interest payment, the risk of these lower quality bonds, the expected total yield to maturity, is never fully realized. This would be the case if the bond defaults or pays later and/or in lower amounts. Puerto Rican bonds provide a current example of how this can happen.
In 2012, interest rates (yields) on Puerto Rican debt was about two percentage points higher than highly rated municipal bonds of similar maturity. Not only were the yields higher than bonds of similar maturity, but the interest paid by these bonds was, and is, exempt from federal, state, and local income taxes, making them very attractive. Bond investors, some of who thought bonds were inherently “safer” than stocks, took the higher yields offered by the Puerto Rican bonds even though the credit quality was lower.
Since that time, Puerto Rico has defaulted, and will likely continue to restructure, its payments. This has caused the price of some bonds to fall from par, or face value, of $10,000, to less than $7,000 (a 30% decline). Bonds with longer maturities have seen their prices fall even further. The lesson for investors is that there really is still no such thing as a free lunch. Investments that offer, or advertise higher returns, invariably involve higher risk, whether they are stocks or bonds.
As an investor, you need to know what purpose you have for the bonds in your portfolio. If it is stability and the preservation of assets; shorter term, higher quality bonds, CDs and cash are for you. If you are willing to accept more risk, longer-term, lower quality bonds may be attractive, but our view is as risk increases, a diversified stock portfolio may be the better investment for this portion of your portfolio.
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