When Buying Low is Actually Buying High

August 13, 2010

By Chris Dardaman, CPA, CFP®, CIMA®, CAIA® 

Most investors intuitively understand that when it comes to stocks, ”buying low and selling high” is a good thing. Yet with bond investing, many do not comprehend how total returns work, or realize that rising interest rates could result in a loss of bond principal. Given the volatility in the stock market over the past few years, investing in bonds may feel safe. Yet a portfolio favoring bonds over stocks could result in a greater loss of principal than the investor is prepared for, when interest rates do rise again. While there are a number of factors that impact bond pricing, we will isolate the impact of interest rate changes in this article.

Bond Basics
Here is a brief quiz to test your bond investing knowledge:

Q: If bond interest rates rise, does the value of a bond go up or down?
A: When interest rates rise, the principal value of a bond drops and the investor loses money. The decline in the price of the bond increases the yield on the bond, bringing it into alignment with other similar bonds. For example, if an investor owned a bond yielding 4% and interest rates rose to 5%, that bond would not be as desirable, since new bonds now pay 1% more interest than the old bond.

Q: When interest rates fall, does the value of a bond go down or up?
A: The investor’s principal goes up (they make money) when interest rates fall. If rates fall from 4% to 3%, the older bond would be more desirable, since it pays a higher interest rate, and one would be willing to pay less for the new bond.

The total return calculation on bonds is comprised of two components: income and changes in principal. The principal value of a bond is inversely correlated with interest rates. From an investment strategy standpoint, you ideally would like to hold longer maturity bonds when interest rates are falling, and hold shorter maturity bonds during periods when interest rates are rising. (If it were only that easy.) Various analytics on maturity, yield, duration, liquidity, and credit quality must also be accounted for. The prices of bonds with longer maturities rise or fall more than bonds with shorter maturities. However, if a bond is held to maturity, it will mature at its face value, or par, and the change in interest rates will not impact its value at maturity.

Where We've Been and Where We're Headed
You will see from the chart above how interest rates on intermediateterm government bonds are currently near their lowest point in history. It has been easy to make money in bonds over the last three decades, in a long-term declining interest rate environment. Bond total returns have averaged 8.8% from the peak in August 1981 to present, substantially higher than their long-term average of 5.4% from 1926 to present. As the chart shows, interest rates cannot go much lower as there is no room at the bottom of the chart. Starting at such a low point in interest rates will likely make it much more difficult over the next thirty years to make historical average returns in bonds.

In the next year or so, we foresee deflationary pressures continuing to build globally given the excess debt, a low capacity utilization rate, and high unemployment. As a result, our concerns about inflation and rising interest rates are over the intermediate and longer-term time frame. Keeping our bond portfolio in the short to intermediate maturity range allows us to capture the vast majority of the bond market returns, but with substantially less volatility than is found on the long end of the yield curve. Our bond strategy currently and for the foreseeable future will be more defensive than normal, including a higher allocation to flexible managers who can change their strategies to adapt to and anticipate changing bond markets, both in the U.S. and overseas. It is important to remember that in a well diversified portfolio, each segment of the portfolio plays a key role. Equities drive growth, bonds provide higher yields than cash with a moderate level of volatility for mid-term planning, and cash covers daily and yearly living expense needs. Rising interest rates does not mean one should abandon their bond portfolio, but the structure of that piece needs to coincide with expectations for interest rate changes. When bond interest rates are very low, it is wise to ignore the adage about buying low … when buying low is actually buying high.