Protecting Your Bond Investments from a Downturn

If you have been following your bond investments recently, you may have noticed that after a nice, steady increase in values, most bonds have lost some value in the last month. Many planners had expected that over time, as inflation returned and normal bond market cycles resumed, we would see interest rates rise and bond values decrease. When the Federal Reserve announced that it would be buying Treasury bonds through its “Quantitative Easing” program or “QE2” as it is known in the financial world, most planners expected that interest rates would drop a bit more and bond values would temporarily rise until the economy improved and modest inflation came back. As inflation and interest rates increase, we normally expect bond values to drop. At this point, the Federal Reserve’s program doesn’t seem to be having the desired effect on some levels (rates are rising rather than falling,) and bond investments have taken the hit. So, the big question is “Is this a temporary phenomenon?” or “Is it time to scale back or change my bond investments?” Well, the answer is…it depends.

Before answering the questions above, here is a little more on bond investing. For the purpose of this article, let’s assume that you hold bond mutual funds. One of the ways that you as a bond investor can tell how your fund will be impacted in case of a change in interest rates is to look at the fund’s “duration”. In general, “duration” is something like an average of the maturities of the bonds held within the fund, and it takes into account some of the other aspects of the bonds within the portfolio. How it is most useful is that you can generally gauge interest rate changes by looking at a bond fund’s duration. If the duration is say two years, for every one percent change in interest rates (such as the Prime Rate,) you can expect a two percent change in the value of your fund. If rates go up one percent, the result will be a two percent drop in value and if rates go down, you will see a roughly two percent gain in value. So, check out your bond funds on a site like www.Morningstar.com and see what your bond market risk is as rates change. Most short-term bond funds will have a duration of just a couple of years or even months. Intermediate-term bond funds may have durations in the three to seven year range. Long-term bond funds, historically the most impacted by interest rate changes, will often be seven years and above for their durations.

Now, back to the current modest downturn on bond funds. What should you do? If you had planned to sell your bond fund, especially a longer-term one sometime in the next 12 months, you may want to sell it now, just in case the value continues to drop. If your investment is of a longer-term nature then you may want to consider these strategies:

• Consider moving the maturity of your bond fund down. So if you are in a long-term bond fund, consider moving to an intermediate-term fund. Or go intermediate-term to short-term.
• Since the bond market reaction to QE2 isn’t completely clear right now, consider a systematic shift from one bond fund to a shorter-term bond fund.
• Consider a systematic shift or new investment to inflation-protected or TIPs (Treasury Inflation Protected Securities) bond fund. Although these funds are down too, on a longer-term basis, if inflation and rates are going to be climbing, beginning to systematically (through a monthly investment program) invest in this kind of fund could offer some protection in the future.
• Don’t forget to look at those tax-free bond funds that invest in municipal bonds. They are experiencing a similar decrease in value although they have other risks and concerns that are associated with investing in the bonds of municipalities which may or may not be doing well as a result of the Recession.
• Consider shifting retirement plan bond holdings over to intermediate-term bond funds for now. Since these investments are longer-term in nature, you are probably better off staying in an intermediate-term fund rather than getting too “defensive” about a potential change in the bond market.

As with many investment changes, it’s often best to take a slower, methodical approach rather than reacting just to the last day’s or last week’s or last month’s news. This change in the bond market and in bond market investments is no exception. Before you act, do some research and then you can build a more well-thought strategy for the future.

FPA member Lisa A.K. Kirchenbauer, CFP®, RLP®, is the president of Omega Wealth Management.