Has a Bond Bear Market Arrived?Submitted by Orange CA Financial Advisor | Sterling Wealth Partners on January 25th, 2018
As we ring in 2018, the stock bull market that started in 2009 continues. The extended length of this bull market (close to historic levels) has caused some people to become concerned about a correction, which leads to considering moving more of their portfolio into bonds. Generally, bonds can be a good diversifier and lower the volatility of a portfolio when added to the asset allocation. But, bonds are also subject to price fluctuations and have their own bull and bear markets. Some economists have indicated that a 40-year bond bull market is coming to an end, and we are now in or near a bear market for bonds.
The Impact of Interest Rates on Bonds
Since 2009, interest rates (as measured by the Federal Funds Rate) have been near zero which is well below the historical average rate. As the economy has strengthened, the Federal Reserve Bank has indicated that it may continue to raise rates. While projections are for two to three small rate changes in 2018, increases in interest rates can have a negative effective on the value of bonds. The gradual creeping up of interest rates, and the expectation of more for 2018 has caused the price of bonds to decline which is leading to the call of a new bear market for bonds.
There is an inverse relationship between interest rates and bond prices. Generally, as interest rates fall, the price or value of bonds rise. Conversely, as interest rates increase, the price or value of bonds decline. This relationship makes sense if you consider the following example: a person owns a bond that pays 3%. Interest rates go up and someone can now buy a bond that pays 4%. This means the value of the 3% bond is going to be lower if the person needed to sell the bond because their bond is paying less than one they could buy today. Generally, the longer the term or duration of the bond, the bigger the increase or decrease in value as rates change. For instance, a 1% interest rate increase will potentially cause a 19.2% decrease in the value of a 30-year bond. If someone owns the bond, they do have the option of holding it until maturity and avoid the price fluctuations as rates change. However, if bonds are owned in a mutual fund or exchange traded fund, they can and often are liquidated by the portfolio manager which creates a risk of loss. As we inch nearer to potential rate increases by the Federal Reserve, it is time to take a closer look at the risk associated with the bond or fixed income portion of your portfolio.
Reducing the Impact of Bear Markets
So, if there is a possible stock bear market on the horizon along with a bond bear market, what are investors to do? Diversification is still the key to lowering volatility. While bonds may be entering a bear market and subject to price declines should interest rates rise, holding bonds in your portfolio will still reduce volatility in relation to holding stocks. Taking it a step further, you can reduce the potential of price declines due to interest rate increases by diversifying the types of bonds you hold in the portfolio. Bonds can be diversified by duration, by corporate vs. government, by credit quality, and by country. Holding a portfolio of bonds that contains short and intermediate term, government, corporate, mortgage, high yield and international bonds can provide broad diversification and reduce risk. In addition, using a “tactical” or “active” management approach in bond investing can also help reduce volatility.
We are entering a unique period where there is risk of declines in both the stock and bond markets. Stocks have had a historic run up in price, and strength in the economy points to the potential that it may continue a while longer. However, all good things come to an end and the correction when it comes, could be hard. With the bond market, the prospect of multiple interest rate increases this year could cause declines in the value of bond investments. They key to minimizing the impact of this potential double whammy is diversification. Let us help you with an independent, objective portfolio review.