By Dylan B. Minor PhD, MS, CFP, ChFC, CLU, CIMA

Currently, the two primary concerns of most all investors are rising interest rates and the specter of inflation. Before considering the state of the world on these dimensions, it is important to step back and review the basics of bonds—bonds 101, if you will. Essentially, a bond investment is simply a loan to some company or government. The company or government then promises to pay back their loan at some future time. In addition, the company or government will most often pay the investor some fixed interest rate while the investor waits for the return of her capital. For example, currently you could loan $100,000 to the US government and it would promise to pay you a bit over $2,500 per year to have the use of your money. The government would additionally promise to pay you back the $100,000 loan in 10 years. Due to a bond’s fundamental structure, there are then three primary risks one needs to worry about when investing in bonds, two of which have already been mentioned:

1) Interest Rate Risk

Let’s imagine one purchases a US government bond that, based on current interest rates, promises to pay 2.5% per year for the next 10 years. If next year, rates rise to 3.5% for a bond that has 9 years until maturity (i.e., when the government promises to return the loan principal), that 10 year bond purchased this year with a 2.5% interest rate will be worth less next year. Thus, the value of one’s bond investment will move inversely with interest rates.

Professionals use a metric called bond duration to assess the degree of interest rate risk. Roughly speaking, a bond’s duration is an adjusted measure of the bond’s length to maturity that estimates how a 1% change in interest rates will affect the price of the bond. For example, the below table reports the average of duration of various bond asset classes. This table reveals that if we are invested in Long Term Bonds, a 1% increase in Long Term Bond yields should result in a 14.71% loss in bond value. In sharp contrast, a 1% increase in short term bond yields, will only result in a 2.46% loss in value.

2) Inflation Risk

Bond investors are also exposed to inflation risk; since a bond generally promises a return of the investor’s original investment at maturity, this fixed value is subject to inflation risk. For example, if expected inflation goes from 2% to 4%, then receiving a fixed amount of money in 10 years is suddenly less valuable, reducing the current value of the bond. The US Government now issues bonds called TIPS, which adjust for inflation. However, historically, the TIPS’ interest rate is simply reduced by the approximate realized value of inflation, resulting in no difference in net return compared with simply owning a traditional US government bond.

3) Credit Risk

Once a bond investor lends money to parties other than the US Government, she faces so-called credit risk. In particular, if the bond investor’s company that she invested in becomes less financially stable, the probability of that company missing an interest payment, or even worse, not repaying all of her principal, increases, which means that her bond will fall in value. Governments can, of course, also fall in credit quality and even possibly default on their commitments, as we’ve recently been reminded of with Greece and some US municipalities.
Of course, all three of these risks are double-sided: they can both decrease and increase the value of one’s bond. The first two risks will often reduce the value of bonds in an improving economic environment, which is our current state of the economy. As the economy improves, the Fed begins raising interest rates and there is increased demand for capital, which also puts upward pressure on rates. Similarly, increased demand in general will supply upward pressure on prices, increasing inflation. However, credit risk during economic growth will typically increase the value of bonds on average, as companies and governments’ credit quality typically improve as the economy improves, providing at least a partial force against the first two risks. For example, although 10 year US Government bonds increased from 1.5% to over 2.5% this past year, 10 year BBB credit (i.e., investment grade) corporate bonds still carry roughly the same yield of 4% that they held last year.

A bond investor can readily determine how much he will get paid for taking on the various risks outlined above by examining the current yields of different kinds of bonds. The table below reports the current premium, or extra bond interest (i.e., extra yield), received by taking on these various risks. To calculate these premiums, we begin with the so-called Risk Free rate. This measure is often the 90 day t-bill rate, which is a 90 day loan to the US government. Since it matures in just 90 days, inflation risk is minimal. As can be seen in the table, currently, there is almost no compensation for investing in a risk-free manner. At times this compensation can be 2-3%. However, in the most extreme period of the financial crisis, the Risk Free rate (as measured by 90 day t-bills) was actually negative, which means that investors were so worried about financial market stability that they were willing to pay the US government to simply hold their money.

Next, we can find the compensation received for taking on interest rate risk by subtracting the Risk Free rate from the 10 year TIP, which is not subject to inflation risk but is subject to interest risk, since it matures in 10 years. Currently, taking on the interest rate risk of a 10 year bond results in a payment of approximately 0.4% per annum. If one instead purchases a standard US government 10 year bond (i.e., without inflation protection), he will receive an additional roughly 2% per annum. This 2% per annum premium suggests that the market expects inflation to be 2% per annum. In short, the market does not expect US inflation to be a problem, at least in the near term. This is also consistent with a slowly, as opposed to rapidly, improving economy. Finally, if someone is willing to take the credit risk of a BBB rated bond, she most likely would earn almost another 1.6% per annum. Thus, in sum, if one is willing to take all three risks, based on the current environment, she most likely would receive roughly 4% per annum until her principal is returned in 10 years.

Another major fear expressed by market participants, which is inextricably tied to interest rates and inflation, is that the Federal Reserve will inevitably reduce its support of the bond market via slashing its monthly bond buying—this currently runs approximately $85 billion dollars per month. Once, the Fed does this, the fear filled argument goes, interest rates must spike. In reality, the Federal Reserve has purchased bonds for quite some time, and its change in course will entail a tapering off of purchases rather than an elimination of purchases, in my view. Below is a chart that provides some historical perspective on the Fed’s bond buying habits:
Source: www.federalreserve.gov

Note: Although information has been obtained from and is based on sources deemed to be reliable, our firm does not guarantee the accuracy of the information, and it may be incomplete or condensed.

Interestingly, most all of the Fed’s dramatic increase in bond buying has come from its inception of purchasing Mortgage Based Securities in 2008. These, of course, are an artifact of the real estate infused financial crisis. Note that before 2008, the Fed was still involved with substantial bond buying and markets somehow still found their way to prosperity. And critically, since the Fed currently does not need to worry about inflation—Omega is currently forecasting inflation in the 1.5-2.5% range—the Fed has the luxury to only increase interest rates as the economy improves. In short, rates shouldn’t rise unless it is to maintain balanced economic expansion.

Nonetheless, whatever the ultimate source of the forces that can raise interest rates and inflation, thus hurting the prices of bonds, one must find alternative places to invest. In the parlance of Omega Financial’s State of the World Wealth Managementtm, we must invest in those things that can survive during the state of the world of rising interest rates and inflation. In short, we need investments that can survive when bonds in general will fall in value.

Recently, pundits have been naming short term bonds as the place to move one’s bond-like investments. I agree that this is good advice. However, as it turns out, it tends to pay to have an overweighting of short term bonds not only in bad times, but also in good times. One measure of the efficacy of a potential investment is to compare how much of the negative and positive returns that it “captures.” To do so, we can use a ratio called the capture ratio, which I have published a couple research papers on (see our website for further information). Unlike past investment returns, historical capture ratios of investments tend to persist into the future, thus proving quite useful as a investment management metric.

To judge the efficacy of short term bonds in good and bad times, I calculated the capture ratio for short term bonds compared to intermediate bonds for the maximum history for which I could obtain short term bond data, which is since August, 1972. As the table below reports, only considering rolling 12 month negative return periods, intermediate bonds averaged a loss of 3.65% per year. During these same negative periods, short term bonds averaged just -.32% per annum. This means short term bonds, on average, only captured 8.9% of the negative returns that intermediate bonds experienced. In contrast, short term bonds captured almost 84% of the return that intermediate bonds had during positive years. Thus, the risk/ return trade off is quite attractive across good and bad bond periods.

In addition to short term bonds, real estate, managed futures, long/short funds, foreign bonds, and stocks are all possible investments that can experience returns differently in a down bond market period. The key is the strategic orchestration of all of these various assets based on their differential exposures to various economic environments and one’s unique risk tolerance and financial goals. It is essential to have truly different assets that can at least survive if not thrive during different economic states of the world. And this is the very heart of Omega Financial’s States of the World Wealth Management.

**Investment in securities carries a high degree of risk which may result in capital loss. Different types of investments involve varying degrees of risk and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this report (including those undertaken or recommended by Omega Financial Group LLC) will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Information contained within and appearing in this report is gathered from publicly available sources that we consider reliable but is not guaranteed by Omega Financial Group LLC.