The Independent Investor: A Taste of Things to Come

If you are a bond holder, the last few weeks may have come as a shock. Ever since the Fed raised the possibility of tapering their stimulus program, interest rates have spiked higher. For the first time in years, bondholders actually saw bond prices decline. Get used to it.

If you are a baby boomer, the price declines in all things that yield interest or income since May 22 might have you wondering what happened to your "safe" investments. All our professional lives we were told that bonds were "safe" for "conservative" investors, widows and orphans and for those among us that find the stock market too risky.

That was sage advice, if somewhat misleading. For the last 31 years, interest rates have been declining. As a result, bond prices have moved steadily higher. It wasn't that bonds, as an asset class, were without risk. It was simply that bonds were in a classic bull market. From 1982 to 2012, for example, the average annualized return of U.S. intermediate-term bonds have been 8.82 percent. In contrast, the S&P 500 Index had an annualized return of 11.14 percent.

So while we were telling ourselves that we were being conservative, in actuality we were riding a wave of speculation betting that interest rates would decline further and further and forever. Well, reader, the buck has stopped here. Interest rates can't go any lower. Nor is the natural order of things for interest rates to remain at historical lows forever. Something had to change and in this case it is the Fed.

The U.S. 10-year Treasury note is the interest rate most investors rely on as a benchmark. The rate on that security has spiked from 1.67 percent to 2.27 percent in 22 days. Some traders believe it will climb to 2.50 percent before it takes a breather. In the meantime, everything that provides some kind of interest or dividend payment has been clobbered in price. U.S. Treasury bonds, foreign bonds, both sovereign and corporate, U.S. investment grade and high yield bonds, even preferred stocks and other dividend paying equities have experienced a downdraft in price.

As a result, there has been a general outcry of dismay from legions of supposedly "conservative" investors. They are suddenly discovering that their money-making investments of three decades actually carry risk, specifically interest rate risk. As interest rates rise, bond prices decline. However, not all bonds prices decline at the same rate when interest rates rise. But right now, investors are not in the mood to differentiate which bonds (or stocks) they should hold and which they should sell. It is a classic case of throwing the baby out with the bathwater.

In hindsight, dividend and interest bearing securities have been in a bit of a bubble over the last year or two. Last year, for example, preferred stocks outperformed common stocks registering gains of as much as 17 percent. That is way above normal for a conservative investment. Junk bonds have been on a tear as well, gaining more than many common stocks over the last several years. Dividend paying stocks have had similar results.

Common sense would dictate that these defensive investments should not be outperforming their more aggressive brethren. I suspect that the prices of these securities, bid up to unrealistic levels over the last months, are simply coming back to earth.

It is understandable that, after three decades of gains, many bond investors have been lulled into believing that conservative and safe meant that, although the rate of interest they received from their fixed income investments could decline, the prices they paid for these investments would always be immune from any downside. It is true that if you bought that 5, 10, 20 or 30-year bond at the initial offering price you will receive the par value of that bond at the end of its life.

But between now and then, if interest rates continue to rise, get ready for some volatility that could makes the stock market look tame by comparison.

Bill Schmick is registered as an investment adviser representative with Berkshire Money Management. Bill’s forecasts and opinions are purely his own. None of the information presented here should be construed as an endorsement of BMM or a solicitation to become a client of BMM. Direct inquires to Bill at 1-888-232-6072 (toll free) or email him at Bill@afewdollarsmore.com.