The capital markets continually set traps for the unwary, and it is financial advisers' responsibility to help their clients avoid them.
The capital markets continually set traps for the unwary, and it is financial advisers' responsibility to help their clients avoid them. The stock market set two recent traps — the Internet bubble and the mortgage bubble — and advisers failed to detect them before their clients lost billions.
Now that the bond market is bubbling, advisers should be warning their clients that it's time to steer clear.
Shaken by losses in the stock market and unnerved by the financial crisis in Europe, investors are still rushing into bonds, despite low bond yields. Year-to-date through April, bond funds had net inflows of $118.7 billion, a 45% increase from $81.9 billion in the first four months of 2009, according to the Investment Company Institute.
In fact, it is the flood of investor money seeking a safe haven that is driving U.S. bond prices up and interest rates down. Investors, it seems, have decided that return of principal is more important than return on principal.
EASY COME, EASY GO
But many investors, especially inexperienced ones in 401(k) plans, are unaware that rising interest rates can tank bond investments along with stocks.
They do not realize that while they may be guaranteed return of principal on government bonds if those bonds are held to maturity, rising interest rates cause bond prices to fall, which means investors could lose money if they need to sell their bonds before maturity.
At some point in the not too distant future, investors — including the government of China — will demand higher interest rates because the rising U.S. debt burden will raise concerns about our ability to meet our obligations.
The spending cuts and tax increases necessary to repay the U.S. debt will slow economic growth and make the burden even heavier, probably pushing interest rates higher.
Holders of corporate and municipal bonds should worry as well, since those issuers can, and do, sometimes default, proving that even return of principal is not guaranteed.
Investors also may not realize that inflation is a great danger to bond owners. Even if they hold their bonds to maturity and receive their invested principal back, its purchasing power will have been greatly diminished.
While some analysts believe the world is likely to experience a bout of mild deflation in the immediate future, there is a very high probability that governments, including that of the United States, eventually will resort to inflation to reduce the burden of debt repayment.
Sophisticated investors, such as Bill Gross, managing director and co-chief investment officer of Pacific Investment Management Co., may be able to identify when interest rates are about to rise and position their portfolios appropriately. But the average investor cannot.
Advisers must warn their clients, and anyone else who will listen, not to fall into the bond bear trap. They should point out that falling interest rates mean rising bond prices, but that the next big move in bond prices likely will be down.
They must encourage their clients to maintain balanced portfolios of stocks and bonds even as stock prices continue to tumble.
Those portfolios should contain some inflation hedges, such as commodity-oriented stocks and Treasury inflation-protected securities.
