I recently asked an investor what he was going to do with some new cash that he just acquired. He proudly told me that he was going o buy some Ginnie Maes of course.
When I asked him how he felt about the future of bonds in light of the current record lows we now see he told me that he has been doing this for 30 years and it has always worked for him.
The fact is that he has been right for all those years and therein lays the danger. Human beings get programmed into thinking that what worked yesterday will of course work today. Bonds have for longer than most people can remember been the risk free investment that insures slow but steady growth. Bonds are also backed by bond insurers like Ambac or PMI. So what could possibly go wrong?
Let's consider what risks there are in a bond.
There are two risks to consider.
Default risk and Reinvestment risk.
Default risk is usually covered by an insurer if it is a municipal bond and or prorate risk is as good as the credit of the company who you bought the bond from.
Reinvestment risk is the risk you take that when you get your principle back at the end that you will not be able to invest at the same rate as you are currently getting.
If rates go up you will be able to get a higher return later.
If rates go down your bond will increase in value and you can sell it as a profit if you choose to.
So what could possibly o wrong?
Well many people who own bonds own them in a bond fund. Buying bonds intelligently requires not only an understanding of default risk assessment but the ability to find the best bonds available at the time of purchase.
A bond buyer must assess the default risk, the reinvestment risk and then manage when various bonds in the portfolio will come due. It is typical to have bonds come due at different times so your reinvestment risk is spread over different times or maturity dates.
As a result of the complexities of buying bonds many people feel more comfortable investing the bond portion of their portfolios in a bond fund.
Now I would like you to spend a few minutes in the shoes of a bond fund manager to get an understanding of why I would not invest in a bond mutual fund.
As we previously mentioned when interest rates rise the resale value of bonds goes down. If you as an individual bond holder know that your bond is going to mature (your going to get your money back) in two years you can simply wit until then to get all your money back, but if you are invested in a fund you do not have that control.
The bad news is that even though your fund manager knows that he simply has to wait until maturity to get all your money back he does not necessarily have the ability to wait as he may be getting requests from other investors in the fund for withdrawals. If the fund manager gets a request for withdrawal he has to sell the now devalued bond at a loss.
As the fund sells more and more bonds for losses it lowers the current fund value and if people continue to see articles like this one and react by jerking money out of the fund it will further reduce the fund value and you develop what is in effect a run on the fund.
The conclusion then is that if you feel that bond yields will be rising anytime soon you should liquidate your holdings in bond mutual funds.
Just because something has worked for 30 years doesn’t mean it will continue to work. Gravity is consistent and we can count but people who are great investors need to constantly asses their holdings.
So where is the next opportunity? It's probably where no one wants to go right now. Real Estate.
As a money manager I have learned that to outperform you must do what others find uncomfortable.
The main reason most people should have someone else manage their money isn't because they aren't smart enough to manage it but mostly because they don't have time to research their holdings which would then give them the courage of their convictions.
Ralph Sesso CFP
312-628-6715
Redwood Partners
221 N LaSalle
Suite 3200
Chicago, Illinois 60601