Investing In Bonds

Investing In Bonds

After Last Year, Is It Still Safe To Invest In Bonds?

Bonds are a good diversifier, when interest rates aren’t at record lows.

Parts of this article were originally published on MakinSenseBabe

Most financial advisors are wussies. They’re too afraid to ditch an old investment playbook that might not work going forward for the same reason we’re too afraid to ditch an old life script that might not be the best thing for us going forward. A script is when different parts of your life feel like variations on the same old story. Living by old scripts is easy, because it’s familiar and therefore comfortable. 

Like, if we’re used to dating people we know we could do better than, just because we’re more afraid of being alone. Or if we’re in a job or career that we don’t like, it’s more comfortable to stay in that job versus starting from scratch with something that may or may not pan out. 

Most people choose what they know and repeat behaviors that they know because the unknown frightens them. 

This is why people got sucker-punched with most of their bond fund investments in 2013. So now financial advisors are standing around scratching their balls trying to figure out if they need to rewrite the rules when it comes to bond investing and adapt to the new environment we’re in. Most are choosing not to. 

The truth is that it’s time to ditch the old bond investing playbook, and here’s why. First…

What Is A Bond?
Imagine you loan your money to the government for 10 years. And the government pays you 3% in interest payments per year for 10 years for that loan. You own a 10-year government bond. 

If you loan your money to a company for 10 years and they pay you 5% interest every year for 10 years, you own a 10-year corporate bond. 

If you own a bond, you gave out a loan and will receive interest in return. 

Why Did The Value Of Some Government Bonds Decrease By Over 10% In 2013? 
Imagine if you loaned your money to a friend for 10 years and they paid you 2% in interest each year. Then imagine the next day they went to another friend and borrowed money from them for 10 years as well. But that other friend said fine, “I will loan you that money, but you need to pay me 3% in interest each year, not 2%.” 

You’re now in a worse situation because that new 10-year loan or bond now pays 3% in interest and yours only pays you 2% in interest each year. 

That’s why, when interest rates go up, the value of existing bonds go down. That’s what happened in 2013. Interest rates hit record lows last year and then went up. 

There are three main assumptions about government bonds that worked over the last 30 years (up until 2013) that need the boot.

Old Bond Playbook vs. New Bond Playbook 

Old bond playbook — “Bonds are safe.” 
New bond playbook — Open your glove compartment. Bonds are about as safe as that melted condom. 

Everyone is used to saying “bonds are safe” because, yes, they have been for the last 30 years. As long as interest rates have been going down, you win on the value of your existing bonds because they’re now worth more since they pay a higher interest rate than the current rate. With interest rates hitting record lows, the opposite has been happening. Bonds aren’t safe. 

Old bond playbook — “Bonds are a good diversifier” 
New bond playbook — Bonds are a good diversifier, when interest rates aren’t at record lows.

Historically, when the stock market sells off, the government bond market rallies. That’s the normal relationship between stocks and government bonds. This is because there’s a “flight to safety” when people get scared in the stock market. They sell stock funds and buy government bond funds because historically, those bonds are safe. 

That relationship works best when interest rates are at average or high levels. So, not right now.

Old bond playbook — “Buy your age in bonds.” If you’re 35, you’d allocate 35% of your investment portfolio to bonds and the percentage would increase as you get older. 
New bond playbook — Tell that to your 65-year-old mom who just lost over 10% in her long-term government bond investments last year. 

Yes, the vast majority of retirees are currently screwed for this reason; they’re not left with many “safe” investment options for their age, given where we are in the interest rate cycle. Buying your age in bonds does not work right now, given interest rates are still well below their long-term average rates and will trend up over time. 

Here’s the bottom line: If you finished this article, congratulations, because, let’s be honest, finance topics are about as fun as watching Lincoln with a history buff. But now that you did, I hope that when you wake up tomorrow you think about a playbook that no longer works in your life and kick it to the curb — along with any other old scripts holding you back.

Kathryn Cicoletti is the founder of MakinSenseBabe, “The Money Site For Non-Finance People. Finance People Are Annoying.” We plow through news that impacts your money and make sense of the important stuff so you can get on with your life. We have no interest in making you a finance whiz, though. Finance whizzes are boring.

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