People have long viewed bonds as a relatively risk free asset class, and who could blame them; since 1983, the Barclays Aggregate Bond Index has had an 8.1% average annual compound rate of return. During that period, it suffered only 3 negative years, with -2.9% being its worst. With interest rates inevitably rising, these numbers cannot continue. Bonds will switch from being risk free to risky. This “great rotation” from Bonds to Stocks will not be done without angst. Investors’ perception of risk will have change and managers who made their careers during the bond bull market will evolve while a new era of asset allocation is ushered in.
While many TV pundits, market strategists, and investment periodicals are touting this impending doom, individual investors still seem to be turning a blind eye as money continues to pour into bond funds. To help get investors’ attention, many firms are now sending out notices to their clients on the risks that bonds pose. FINRA, the largest independent regulator for securities firms doing business in the United States, recently wrote an investor alert on the risk of bonds in hopes of finally catching people’s attention. In it they said;
Currently, interest rates are hovering near historic lows. Many economists believe that interest rates are not likely to get much lower and will eventually rise. If that is true, then outstanding bonds, particularly those with a low interest rate and high duration may experience significant price drops as interest rates rise along the way. If you have money in a bond fund that holds primarily long-term bonds, expect the value of that fund to decline, perhaps significantly, when interest rates rise.
FINRA is a regulator; therefore, they choose their words very carefully and are always looking out for the client. So when they say things like, “significant drop” and “expect a decline,” it might be time to start rethinking your bond positions and where they might fit within your overall allocation for the future.
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Source: FINRA Duration—What an Interest Rate Hike Could Do to Your Bond Portfolio