PART OF YOUR PORTFOLIO?

WRITER: TOM RUGGIE, CHFC, CFP

Just when investors feel they have recovered from the stock market crash of 2008, a new threat could potentially hit portfolios in an area many think of as safer than stocks: the bond market.

Recent headlines like “Danger Lurks Inside the Bond Boom” (The Wall Street Journal), “How Banks Could Get Blown Away by Bond Bubble” (Fortune), and “Beware the Bond Bubble in 2013” (CNN Money) are raising real concerns among investors that the bond bubble is reaching a breaking point.

What is the problem?

Interest rates are at historic lows. That makes bond prices relatively high with virtually nowhere left for rates to go but up. That might be good news for bond buyers in the future, but terrible for those stuck with bonds at low rates.

Bond funds, a favorite of conservative investors and those nearing retirement, would be hit particularly hard as their existing holdings would rapidly lose value.

Why worry now?

Federal Reserve Chairman Ben Bernanke recently spoke about the path ‘quantitative easing’ (QE) — the Fed’s bond-buying program aimed at lowering interest rates, raising bond yields, and spurring economic growth — may take in coming months.

Under QE, a central bank purchases government bonds from private sector companies or institutions (typically insurance companies, pension funds, and Wall Street banks).

Since Bernanke’s comments about QE aired, it has been like watching a game of ‘telephone’ where one child whispers something to another child and that child whispers to another child and so on until the last child says out loud what he believes he heard. By then, the original message has been transformed.

Bernanke actually said (using an analogy about driving a vehicle for clarity): “…if the incoming data support the view that the economy is able to sustain a reasonable cruising speed, we will ease the pressure on the accelerator by gradually reducing the pace of (bond) purchases. However, any need to consider applying the brakes by raising short-term rates is still far in the future. In any case, no matter how conditions may evolve, the Federal Reserve remains committed to fostering substantial improvement in the outlook for the labor market in a context of price stability.”

But once this had been filtered through analysts and media outlets and finally reached investors, what investors heard was “sell.”

That sell message then rippled through stock, bond, and other markets around the world. As markets fell, interest rates rose. Investors’ fears were reflected in the so-called investor fear gauge known as the CBOE Volatility Index (VIX), which measures the market’s expectations for volatility during the next 30-day period. The week of the news conference, the VIX started the week at 10.2 percent and finished at 19. An equity strategist quoted in The Wall Street Journal shortly after Bernanke’s comments said, “…there are much higher probabilities for market gains when the VIX is between 10 and 15 than when it is in the 20-25 range...”

So, will markets settle? Or, will volatility continue?

Only time will tell.

There are questions that require answering: “How long will QE continue?” “Will it be tapered slowly?” “Are there increasing doubts about continuing QE past this summer?”

Markets are watching for clues about what the Fed’s are thinking and how the bond and equity (stock) markets would react to a change in the QE rate.

So far, there is sensitivity that Bernanke may be overestimating the strength of the U.S. recovery and underestimating what tighter money could do to the economy. There are fears that mortgages that are more expensive could topple the still-fragile American housing market.

That said, according to Bernanke, the Fed might not actually raise rates in a meaningful way for at least the next few years. In fact, he named an unemployment rate of 6.5 percent as the Fed’s threshold for pulling back.

What to do?

The answer to the concerns raised about bonds will be different for each individual investor. Caution is warranted not just for fixedincome investors who are looking for relative steadiness, but for investors in all risk assets.

Anticipating this change, we have developed numerous options for clients to consider when protecting their long-term, “conservative” assets while still generating returns beyond a savings account or CD.

To find out how the changes in the bond market will affect your investments and what you should watch out for, the best course is to talk to an independent advisor who has successfully navigated market and economic cycles and is flexible enough to look at your best interest.