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Home / Expert Opinion / Money Management: Bond bull becomes a bond bear

Money Management: Bond bull becomes a bond bear

George W. Karpus

George W. Karpus

For the last 35 years I have been bullish on bonds. Investors have generally received attractive total returns with minimum credit and volatility risk. However, with the federal funds rate continuing to hover near zero and the Federal Reserve creating an extra $1 trillion per year (by buying $85 billion per month in mortgage and U.S. Treasury securities), interest rates have been driven to extremely low levels, causing a “bubble” in the bond markets. In essence, bonds are no longer as attractive of an investment as they may once have been.

For purposes of illustration, consider the following rates on money market funds and certificates of deposit:

Money market funds &

money market accounts

0.1%

2 ½ year certificates of deposit

1.0%

5 year certificates of deposit

1.6%

If taxes consume 1/3⅓ to 1/2 of this return and future inflation is 2 percent annually, then these shorter-term investors/savers are guaranteed a negative real return.

Should an investor commit for a longer time period and interest rates were to rise, the value of the investment would drop significantly. For example, let’s examine what happens to the value of a 10-year Treasury note and 30-year U.S. Treasury bond if interest rates were to rise.

 

Current

Price if Rates Rise

Price if Rates Rise

 

Price

by 1% in 2 Years

by 2% in 2 Years

10 Year 2.5% U.S. Treasury  $100  $93  $86.7
30 Year 3.5% U.S. Treasury  $100  $84  $70.7

If you own a 30-year U.S. Treasury bond that pays 3.5 percent per year in interest and interest rates rise to 5.5 percent in two years, the bond’s value will drop nearly 30 percent. Thus, over 8.5 years of coupon return would be lost to the bond’s price decline.

Bonds also are not as safe as they used to be. With elevated debt levels across many developed markets, there are significant headwinds facing these countries’ abilities to repay all principal and interest over a 30- to 40-year time period.

Historically, the long-term return from the bond market averages nearly 6 percent. The highest government bond yields today are only about half of this long-term average. This makes bonds considerably more volatile, with only half of the total return potential. To address today’s realities, investors should limit their fixed income allocation to an amount that will allow them to meet their cash flow needs for the next five to 10 years and invest the rest in stocks and alternatives.

Most importantly, investors need to realize that today’s markets are going to be more volatile. Investors no longer have a safe haven in short- to intermediate-fixed income investments that make any sense. Accepting and living with that volatility will be the most difficult task for investors in the future.

Focus on your long-term investment objectives, stop agonizing over you investments on a daily basis, and accept that we are living in a world where greater volatility will be the norm for a well-run investment portfolio.

George W. Karpus is chief investment strategist and chairman of the board of Karpus Investment Management, an independent, registered investment advisor that manages assets for individuals, corporations and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.