Friday, May 13, 2011

The Problem with Low Interest Rates

If you're a conservative investor - and lots of my clients are - you probably have a significant portion of your investment portfolios in bonds.

Bonds, of course, offer the twin benefits of principal stability and moderate amounts of income.

In addition, if you invest in individual bonds (as opposed to a bond mutual fund), you have the additional comfort of knowing that the par (face) amount of the bond will be returned to you at maturity, regardless of the level of interest rates.

But here's the problem today: rates are low on bonds, especially on shorter maturity bonds.

For example, 5 year Treasury note yields at 1.8% don't look all that appealing - except if you compare them to a 5-year AAA-rated municipal bond, which yields 1.3%.

Longer maturity bonds offer more yield, but could also drop in value if rates rise just a little bit.

10-year Treasury notes now yield 3.18%. If rates rise just 40 basis points - and the 10-year yields around 3.6% - the total return (price change + income) will be negative.

And rates were 40 basis points higher just a month ago, in early April.

Now, if you're a "buy and hold" investor, this shouldn't be cause for alarm - after all, if you're just holding a bond for income and price stability, fluctuations in market value prior to maturity is really more of an academic exercise rather than cause for concern.

But if you are the type of investor that likes to look at performance fairly regularly - and likes to make comparisons versus benchmarks - the vulnerability of bonds to even small changes in interest rates should be something that you're aware of.

I'm going to do more work on this subject next week, but my initial work would suggest that upping ones allocation to dividend-paying stocks in lieu of bonds (especially relative to shorter maturity high quality bonds) might make more sense for investors, even ones that consider themselves "conservative".