Bond Teeter Totter

October 1, 2013 

We've probably all been on a teeter totter, also called a seesaw. When one side goes up, the other side goes down.

Unfortunately the same concept often applies to taxable corporate bonds, tax-exempt municipal bonds, preferred stocks and other fixed income securities because they are interest rate sensitive.

Whether held individually, in a managed fund, or other packaged investment, they may be affected by interest rates.

Think of one side of the teeter totter as interest rates and the other side as the principal value of the investment. When one side goes up, the other side goes down.

Two basic things to consider in investing are the interest -- what the investment pays you -- and the principal -- the value of the investment. Sometimes they work in your favor and sometimes they don't.

For the last 30 years or so, long-term taxable bond interest rates declined from the area of 12%+ to maybe 6% or so on fixed income bonds maturing in 20 to 30 years from their issue date. Like the teeter totter, that means when interest rates

went down, bond prices went up. It's a double positive effect. That was good.

But now there is the threat that sometime in the future interest rates may be going up, which means bond prices are going down. It's a double negative effect. That is bad.

A word tries to explain this: duration. In February 2013, FINRA, the Financial Industry Regulatory Authority, issued an Investor Alert as part of its Investor Education Series. The two page article, "Duration - What an Interest Rate Hike Could Do to Your Bond Portfolio," is available at www.finra.org.

FINRA says that duration signals how much the price of your bond investment is likely to fluctuate when there is an up or down movement in interest rates.

The higher the duration number, the more sensitive your bond investment will be to changes in interest rates.

As an example, FINRA wrote that a BBB medium investment grade corporate bond with a duration of 14.5 might experience a loss in principal of 26 percent if interest rates were to rise by two percent from today's low levels.

Remember the stock market and real estate crashes of 2008? The bond market crash may be somewhat similar. So you might wonder about ways to protect yourself.

One way is to lower the duration. But then income may decline and some principal.

Imagine trying to re-gain that principal especially if interest rates continue to rise. Let's say you do lose 26 percent of principal, which means $10,000 declines to $7,400. To get back to $10,000, what percent gain is required? It's not 26 percent but 35 percent.

Don't believe it? If a stock at 20 declines in one year to 10, that is a 50 percent loss. If the stock at 10 now rises to 20 in one year, it's not a 50% gain but a 100% gain. In this example, it's twice as hard for the price to return to 20.

Another problem is inflation. If you bought a $10,000 bond today for $10,000, suppose it matures in 20 years and you get your $10,000 back. But your purchasing power will be far less.

Roughly speaking using simple interest, 3 percent inflation for 20 years = 60 percent. At maturity in 20 years you will get back the $10,000. But inflation would decline the $10,000 by 60 percent to only $4,000 of actual purchasing power.

Using compound inflation, the loss is about 84 percent and the purchasing power is reduced to about $1,600.

But what happens if you need the money, you die and the kids inherit the principal, etc? That's a big potential loss to you and them.

And remember that a fixed income bond paying 4 percent will pay 4 percent until the bond matures. Would you agree to a fixed income salary during your working career? Why accept a fixed income during your retirement career?

It seems the cost of bread, health care, and most everything are going up. Make sure part of your portfolio has the chance for income growth.

There might be high yielding stocks to consider that pay good income. Frequently, stocks raise their cash dividends.

You can transfer some of the risk of investing to an insurance company and get a lifetime income.

There are alternatives. Talk to your financial planner.

James "Jim" Zientara, a Financial Planner and Branch Manager with Raymond James Financial Services, Inc., can be reached at (941) 750-6818.

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