Is There a Bond Bubble about to Burst?

Friday, April 29, 2011

Dan Forbes, GoLocalProv Financial Expert

Fed Chairman Ben Bernanke’s speech on Wednesday did little to alleviate the fears of those that believe fixed income securities are standing near the edge of a cliff. Bernanke expects the economy to slowly rumble along and sees the recent uptick in inflation as being temporary. Interest rates will hold steady near historic lows for the time being. But everyone agrees that rates are going up soon, so what are you on the lookout for when it comes to your bond investments?

The Fed is out of options

The Federal Reserve has a few courses of action it can take to alter monetary policy. They set the discount rate which they can’t reduce any lower. They’ve increased bank reserve requirements. And through the end of June, they’ll complete the second round of “Quantitative Easing” (QE2) in which they expand the money supply. But the Fed’s job is to simply provide an atmosphere where the economy can grow. While Fed policy has always been important, we’ve reached a crucial point where investors are reacting almost solely on what comes out of Fed meeting minutes. It’s like the referees controlling the outcome of a game as opposed to the participants. Bernanke stated that with QE2 coming to a close, they’re going to forego QE3, monitor from the sidelines going forward and let the “game” take its course. That’s important. The third quarter could provide volatility on the bond and equity side when the training wheels come off. If the economy remains stable or shows further sign of improvement, get ready for an interest rate increase.

Duration

The calculation of a bond or a bond mutual fund’s duration helps tell us the investment’s sensitivity to a change in interest rates. The longer the duration, the more sensitive the bond is to a change in rates. Using the coupon that a bond is paying, the frequency of payments, and the years until the bond matures, we can calculate duration to get an idea of how the bond value will react when rates eventually start to rise. Check your bond investments – it’s time to shorten the duration.

Funds vs. Individual Bonds

You invest in bonds for two reasons – diversification and income. If you have a large enough portfolio, you can ladder your bond holdings, collect the income, and hold the positions to maturity. For those using mutual funds or ETFs, use funds that have shorter durations. There are even funds that specifically hedge against interest rate risk by trying to reduce duration to zero. Other funds have a “floating rate” objective that should adjust their yield in accordance to interest rate increases.

Alternatives

If you’re really a Nervous Nellie, there’s always the option of the bond portion of your portfolio in cash, taking the minimal return and riding out the storm. In retirement plans that offer it, such as TIAA-CREF, you can utilize the “fixed”, “guaranteed”, or “stable value” within the plan. And, finally, you can be sure there’s an insurance agent out there ready and willing to put you in a fixed, indexed, or variable annuity.

Dan Forbes is a regular contributor on business financial issues. His office is in Providence, RI. He leads the firm Forbes Financial Planning and can be reached at [email protected]