Thinking About Bonds

It seems like interest rates for savers (savings accounts, money market funds, CD’s, etc.) have been at 0 percent for all intents and purposes for a long time now. Treasury Notes, the highest quality, have been stuck near half of 1 percent for two year maturities and roughly 3 percent for 10 year maturities. Now, with inflation rising at least in terms of food and gas, it’s become very difficult to generate reasonable interest income.

Earning 0 percent in an economy where prices are rising anywhere from 2-3 percent constitutes a real loss of buying power on an annual basis. Savers of all types are being forced to come to grips with that reality. In terms of purchasing power, it’s the equivalent of taking a 3 percent cut in value every year with the added indignity of compounding over time. That means a dollar today will buy .97 cents of goods a year from now, and approximately .84 cents of goods five years from now. Everyone is feeling this, but because it happens slowly, it’s difficult to recognize. 

Over many years, our professional view of the risk and safety of bonds and bond portfolios has changed. Unless we can create more income in a portfolio, we are forced to accept the slow erosion of value in our accounts. Years ago,  when Treasury interest rates were in double digits, it was an easy decision to opt for the relative safety of US guaranteed notes over other riskier offerings. It’s not so easy in today’s world. Now, bonds come in many flavors and shapes, both US based and international. The past two decades have seen tremendous growth in markets outside of the US, and international bonds have become an important part of diversified portfolios. 

All bonds have risk, even treasuries. Since our government can create additional dollars, treasury obligations are assumed to carry no default risk. True enough, in spite of our debt ceiling debates. However, treasury notes do have interest rate risk and the price of treasuries can vary from a little to a lot depending on both length of maturity and amount of change in market rates. Other bonds also carry interest rate risk, but have additional factors that can influence the behavior of the bond or bond sector in different ways. For example, corporate bonds are affected by events specific to a corporation, or sector (ie..finance) and can also be more generically influenced by the overall direction of the economy.  High yield bonds are more likely to be influenced by economic conditions and specific events, and somewhat less by changes in overall interest rates. International bonds are influenced by events outside of our domestic conditions, even though global markets have become more correlated over the years. By blending various components of risk, a portfolio can be created that is diversified and can generate some incremental income. 

A portfolio like this is not without risk, although prudent allocations and management can help to control overall volatility. A savings account may feel like the safe option, particularly for those who like to see a stable balance, but it is in fact losing value at a steady, if not accelerating pace. Which is the riskier option? An account that can generate some positive yield but that could incur some price fluctuation, or an account that locks in an erosion of value in return for a stable price? The answer is not a simple one and may depend on many different factors unique to your situation.

Ron Brault, MBA,CFA