Why Bonds May Be More Riskier Than Stocks

In the current environment of rising interest rates, I wanted to make sure that you were of aware of the potential risks of owning bonds, particularly bond mutual funds and bond exchange traded funds.

The general consensus among investors is that bonds are typically considered safer than stocks.  A couple of the reasons include:

• Bond investors are higher in the pecking order than stockholders to get their initial investment back if the company goes bankrupt.
• Companies that issue bonds have an obligation to pay the promised interest rate to investors.  Companies do not have an obligation to pay dividends to stockholders.
• Bond prices are usually less volatile than stock prices.

Bonds trade just like stocks: their prices fluctuate as investors buy and sell them throughout the day.  Also, when a bond price changes, so does its interest rate, but in the opposite direction.  So, if a bond price goes up, its interest rate goes down, and vice versa.

As we said, interest rates are rising right now.  This affects bond prices because new bonds will have higher interest rates than older bonds.  Bonds with higher interest rates are more desirable, all else being equal.  That means the lower interest rate bond prices drop because there is less demand for them.  This isn’t a big deal if you buy an individual bond and hold it until it matures – the date when the bond goes away and you get your original investment back.

The problem occurs when you own bonds in a mutual fund or etf.  Technically, these investments have no maturity date because they continuously buy bonds.  This is risky when interest rates are rising because this will cause the mutual fund price to drop.  Most of the time, I find this situation when reviewing someone’s holdings in their 401k plan.  They usually own some type of bond fund as part of a general strategy that their 401k provider has shown them.

Since it looks like we are at the beginning of a rising interest rate period, you definitely want to evaluate your bond strategy in current investment portfolio.  If you do want to own bonds, please consider owning individual bonds that you plan on holding until maturity and make sure the maturity date is 2 years or less.  If you must use bond funds, use funds that only buy short term maturity bonds.  These bonds are less affected by rising interest rates.

This strategy can be a little confusing to understand so if you have any questions, please let me know.
Joe Baker, CFP®
Baker Asset Management, LLC
joebaker@bakerassetmanagement.com