When The Bond Market Goes Bad – Does Bad Mean Good?

Bond MarketI’m reading some scary headlines about the bond market crashing.

It sounds like bad news, but could it be good news for your retirement portfolio?

The pundits are concerned about the changes in interest rates.

Bond Market

In November 2015, interest rates for 20-year treasuries reached a high of almost 2.7%. By July 2016 they dropped to a low of 1.7%. By October rates came back to approximately 2.2%. In the course of a year interest rates dropped around 1% and then regained about half of the loss. That’s a “Powder Keg Ready to Blow?”

Who is going to lose and why?

Retirees buy bonds for income certainty. They lend their money expecting a guaranteed rate of interest over the life of the bond. When the bond matures they look for another. These are investors who look for safe bonds paying good interest and expect to hold them to maturity.

Today’s low interest rates cause many retirees to worry about running out of money before they die. Most would cheer if interest rates for quality bonds climbed back to 6-7%.

The second group of bond buyers is traders or speculators. They do not buy bonds for yield expecting to hold them to maturity. They are speculating on the changes of interest rates working in their favor.

Let’s look at some risk factors and how they impact each group.

Interest rate changes. Assume a trader buys $100,000 of 20-year treasuries at par (generally $100 face value) paying 2% interest. A year later the interest rates for treasuries rises to 3%. The trader can hold on to the bond until maturity. For the 19 remaining years it may pay a lower than market interest rate. They also can resell the bond in the aftermarket; however they will have to drop their price below par due to the change in rates. No buyer would pay full price for a 2% bond, when there are current bonds paying 3%.

The resale value of the bond is calculated using a formula called “modified duration”. The formula factors in interest rates with the remaining life of the bond. Investopedia provides us with a handy tool for these calculations.

I entered a par value of $100, annual coupon rate of 2.7%, the November 2015 high. I set the settlement date of November 1, 2035, 19 years later. The modified duration is 14.71, explained as:

“The duration of a bond with a par value of $100.00, a coupon of 2.70%, and a maturity on 11/01/2035 will increase to 14.71 with a 1% … increase in interest rates.

What does this mean to you? Modified duration provides a good indication of a bond’s sensitivity to a change in interest rates. The more your duration changes with a 1% increase in interest rates, the more volatility your bond will exhibit. The bonds with lower coupons and longer maturities tend to have greater price volatility than bonds with higher coupon rates and shorter maturities.”

Our bond trader who purchased $100,000 in 2.7% bonds is currently sitting on a gain of approximately ½ of 14.71%. The current interest rate (2.2%) is .5% lower than the coupon rate of the bond. In July 2016, when interest rates were 1% lower, the gain would have been approximately 15%.

Readers should understand this is a mathematical estimate. The bonds would have to be resold in the aftermarket and would be subject to the normal market law of supply and demand.

Speculators buy long-term bonds because they have greater volatility to interest rate changes. They are betting on the fact interest rates will go down and they can resell their bonds at a profit. The opposite is also true. Had interest rates gone up 1% in a year the speculator would have lost approximately 15%.

Many traders bought Zero Interest Rate Bonds. They anticipated interest rates would go even lower and they could resell the bonds at a profit.

Whose powder keg is about to blow? Interest rates are starting to go back up. Our government debt has skyrocketed and traders hold trillions of dollars in long-term low interest treasuries. The same holds true for corporate bonds. Traders are going to have to sell their positions or take huge losses.

What about retirees? Long-term bonds pay higher interest rates because the buyer is assuming more risk; like inflation or interest rate changes. Investors must be very careful not to get hooked and buy any bonds (or bond funds) that they are not willing to hold to maturity.

A bond fund or ETF, regardless of whether it is short-term, intermediate or long-term should quickly see their daily closing prices rise and fall with interest rate changes.

Liquidity Risk. The duration calculations are estimates based on a free market with an equal number of buyers and sellers. What happens if the big-boy traders are using computer generated sell orders and put in several billion in a short period of time? What happens if bond funds have thousands of customers put in sell orders to get out of the fund? They may have trouble selling the bonds and the prices could drop to panic levels.

Bond funds of all types are required to keep a certain percentage of their assets liquid to cover redemptions. In a normal market the system has worked; however a run on bond funds could cause some catastrophic losses.

Funds, needing to sell assets quickly to raise cash for redemptions, would likely sell their best bonds. They are more liquid and would garner better prices. Those who did not sell their shares may find the remaining inventory of bonds being lower quality with higher default risk.

Many funds have small print provisions regarding redemption. Your fund may not be as liquid as you think. Equities.com writes, “Bond Funds: A Bigger Risk Than You Think?” In bold type they tell us:

“We do not know when the next crisis is coming, but we believe that a prudent investor in bond ETFs or mutual funds would do well to know something about the liquidity of the actual securities underlying their fund shares.

Particularly, bond markets are not as liquid and not as transparent as stock markets, and it is possible that funds with exposure to illiquid bonds – or bonds that become illiquid during a crisis – could prove a greater risk to investors than they currently believe. … We believe interest rates will rise, and that bonds will be very unprofitable to own.”

I asked my broker about the funds hedging against liquidity. He suggested investors read the small print in the prospectus because each fund is different. He provided a good example from a large fund:

“… (R)edemptions of Fund shares may be suspended when trading on the NYSE is restricted or during an emergency which makes it impracticable for the Fund to dispose of its securities or to determine fairly the value of its net assets, or during any other period as permitted by the SEC for the protection of investors. Under these and other unusual circumstances, the Trust may suspend redemptions or postpone payment for more than seven days, as permitted by law.”

A clause like the one above gives the fund the right to sell when it is in their best interest, not yours.

What to do now?

1. Review all your bond holdings. Are they liquid? Are you willing to hold the bonds or fund until maturity?

2. Don’t chase yields. It’s easy to get caught up in the need for higher interest rates and go for longer-term bonds. The differential in rates between very short term and long term do not compensate for the additional risk.

3. Hold short term only. The interest rates for all safe bonds do not beat inflation. Even intermediate bonds are risky today. Five year, AAA bonds are paying 1.68%. Treasuries are even lower.

4. Cash is good. Right now a one-year CD is paying 1% interest. Why hold a five-year AAA bond for an additional .68%? You can currently buy a 6-month CD and earn .65%; it is FDIC insured and liquid. Ladder your CD’s for safety and liquidity.

5. Don’t be in a hurry. Until the dust settles from the election, no one knows where the economy is going. Retirement money must be protected at all cost. Speculation and trading should not be in the vocabulary for a retirement portfolio.

When I was with Casey Research we had a conference call discussing bond risks. The analysts were talking math formulas using technical terminology. My analyst, a Chartered Financial Analyst named Andrey Dashkov paused and said, “Dennis let me explain this in terms you will understand. Stay away from risky stuff!”

Let the speculators and traders do their thing. Retirement money needs to stay away from risky stuff. When the dust clears, bad can mean good for those who waited.

On the Lighter Side

We will not publish on Thanksgiving Day. It is time to enjoy your family and give thanks for many blessings. Speaking of giving thanks…

We have a special Veterans Day Celebration in our little town of Anthem, AZ. I urge you all to watch this short news clip about out unique monument.

While I served our country, I am no hero. I was one of the lucky ones; too young for Korea and honorably discharged before Vietnam. I go to honor those who were not so lucky.

As we arrived, an adorable little girl in a brownie uniform, missing front teeth, came up and asked, “Are you a veteran? My wife nodded, knowing my hearing is so bad I likely didn’t hear her well. She handed me a hand drawn card with a flag on the front and a note inside:

“Dear Veteran, Thank you for serving our country. Your service is appreciated. From Troop 439”.

Early in the program they asked all combat veterans to stand. They began with WWII. Perhaps six men struggled to their feet. All were hunched over. One had a cane, another holding on to the handles of his scooter.

They received a round of applause and all sat down. Next they asked for Korean combat veterans to stand. Tears ran down my cheeks when I saw three of the WWII vets once again struggle to get to their feet. I served with many pilots who flew in both wars. I looked at those 90 year old men standing and realized they were peers of the men I looked up to and respected as a 19 year old.

All the combat veterans that stood are the real heroes and deserved all the thanks and tribute.

Our memorial is only five years old and is becoming famous. The couple sitting behind us told us they came in their motor home. When they first learned about it, they added it to their bucket list.

It may sound corny, but small town America is still alive and well.

And finally…

Our keynote speaker was a navy Admiral named Miller (no relation). He told us a short story.

A grade school boy was given a project to interview a combat veteran. The boy started with the easy stuff like branch of service, where he served, etc. Then he paused, took a deep breath and asked, “Did you ever kill someone?”

The veteran paused and said, “Probably”.

“Probably?” the boy asked.

The veteran smiled and said, “I was the cook.”

Happy Thanksgiving everyone!

Until next time…

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