How can I get hurt holding bonds?

I am considering buying bond funds and would welcome your recommendations. I recently read in Time magazine that you could get hurt if you’re invested in a bond fund. How can I get hurt holding bonds?


Many people think bonds are risk free, but that is not actually true. There are multiple risks associated with bonds, but they can be an extremely important component of a portfolio despite those risks. And, if properly allocated, they can provide a level of security above and beyond the equity markets. Of course there is no free lunch, and the added stability of bonds requires a tradeoff. Namely, you are foregoing the equity premium associated with stocks.

We recommend using a mix of high quality short- and intermediate-term government and Treasury issues. For tax-deferred accounts we include Treasury Inflation Protected Securities (TIPS). This allocation is purposefully designed to be very conservative. Nonetheless, it is still subject to certain risks. Interest rate and inflation risk make the top of the list. You can alleviate the risk of inflation through the use of TIPS. Interest rate risk is somewhat of a different story.

There is an inverse relationship between bond prices and interest rates. As rates rise, bond prices fall and as rates fall, bond prices rise. Longer-term bonds are hit hardest in a rising rate environment; short-term issues are hurt the least. Of course shorter-term issues generally pay less interest. If you want an appreciable return – especially in today’s low rate environment – you need to extend beyond extremely short-term debt. Our solution is to limit risk exposure and also gain some additional yield by using high quality short- and intermediate-term US government and Treasury debt.

Are dividend-paying stocks good bond substitutes?

A rose by any other name would smell as sweet.

With bond yields so low, is it a good idea to substitute dividend-paying stocks for bonds? Some would say yes, since dividend-paying stocks yield more than some bonds, and have more upside potential.

However, I don’t think this is a good strategy.

Obviously, dividends are an important component of stocks’ total return. From 1930 through October 2010, for example, dividends provided 45% of the annualized percentage gain of the S&P 500. Dividends also help sustain portfolio income when interest rates are low.

But there’s no getting around the fact that stocks, including dividend-paying stocks, are generally more volatile than bonds. Substituting dividend-paying stocks for bonds will lead to a higher risk portfolio.

Let’s take an example of how volatile dividend-paying stocks could be. We’ll look at three exchange traded funds (ETFs). The first is SPY, which tracks the S&P 500. (more…)

Interest rates and bond portfolios

As anyone who has recently refinanced a mortgage knows, interest rates are near historic lows. Low interest rates are good for borrowers, but not so good for lenders. This is important to remember because investors who buy and own bonds are lenders.

To help illuminate the risks and rewards of owning bonds, here are five key concepts that are worth keeping in mind. (more…)

Inflation and our Merriman bond portfolio

Here’s an article we recently mailed to Merriman clients, addressing some inflation questions that we felt our FundAdvice readers may also be interested in:

Some investors are concerned about the prospect of future inflation, based on fiscal and monetary measures the U.S. government has taken to respond to the recent market crisis. However, other metrics suggest that moderate inflation will continue. These include current inflation, bond market indicators and worldwide excess capacity.

Merriman’s recommended bond portfolio is structured to provide a reasonable level of protection against inflation.

The Fed’s view

The Federal Reserve, in a statement on April 28th said, “With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.”

Notwithstanding this reassuring if somewhat abstruse statement, there is considerable debate about whether higher inflation will result from the fiscal and monetary actions the federal government used to curtail the market plunge from October 2007 to March 2009. Inflation is the nemesis of bond investors. An increase in inflation will cause an increase in interest rates and decrease the value of bonds. Conversely, if interest rates were to fall because of lower inflation, bond prices would rise.

What factors impact inflation and how is our bond portfolio structured to handle inflation risk? (more…)