Warm Days and Thunderstorms: Bond Prices Are Rumbling

Spring arrived early for 2012. In spite of the predictive powers of Punxsutawney Phil, the cherry trees along the tidal basin next to the National Mall are in full bloom – weeks ahead of their “normal” cycle.

Spring brings us out of the dullness of a barren winter and helps remind us that change is inevitably constant. Faced with this reality, smart investors continually seek to manage unforeseen risks and uncertainties. We at Farr, Miller & Washington have a balanced approach to portfolio management. We seek investments that are likely to benefit from the long-term growth in the global economy. At the same time, we place high value on an investment’s ability to withstand turbulent economic times. This approach has suited us well since we opened our doors in 1996.

The bond market has become a source of consternation for many investors in recent years. Following a 30-year trend of falling interest rates, many investors justifiably wonder if bonds are a smart investment. We have our opinion, but we don’t have a definitive answer. In any event, bonds do have a place in many investor portfolios, depending on a variety of different factors. In general, many of our clients hold bonds to provide stability and income to their portfolios. Typically, when the equity markets deflate, bonds get a breath of fresh air and smooth the overall portfolio values.

Last week we saw the other side of the coin as the DOW surged through the 13,000 barrier, hitting highs that have remained untested since pre-crisis 2007. Yields on the 10-year Treasury, in turn, leapt from below 2% to the current (as of this writing) return of 2.38%. Remember that as bond yields rise, bond prices fall.

During historical economic recoveries, bond prices fared a good deal worse than they have in the current recovery. This is because the Federal Reserve and Treasury Department have taken enormous actions to keep yields low, thereby increasing the odds that the recovery becomes self-fulfilling. The recent year’s experience of near-zero interest rates has been unexpected. But it may be that we are seeing the rate tide turn.

Past Farr Views have warned of risks to bondholders in rising rate environments. The current jump in the 10-year yield from 1.85% in January to 2.38% on March 19th meant that the price fell from $101.35 to $96.66, or 4.6%. Obviously, investors who purchased 10-year notes with a 1.85% yield to maturity will suffer if they have to sell today. Moreover, returns will only become more negative as yields rise further. Should rates rise to 4%, the price on the US Treasury 2% of 2/15/22 will fall to $83.78.

Naturally, there is no way to know whether this jump in rates is just a blip or the beginning of a trend. But being aware of potential threats is every investor’s job. Our strategy for bonds has been defensive for some time. Average maturities and durations have been shorter, and purchases have been well-researched and opportunistic.

If you own bond mutual funds, check the price action over the past couple of months. If your exposure to rising interest rates is unacceptable to you, it may be time to consider re-allocation. Interest rate movements affect almost every type of investment in some way, but bond investments will react with direct negative correlation. The rule for bond investing is that the lower the coupon and the longer the maturity, the more volatile prices will be. Therefore, higher coupons and shorter maturities mitigate volatility, and therefore, risk.

The tide in the Tidal Basin may be changing. As soothing as 80 degree March afternoons can be, we diligently prepare to avoid the bite of a late market frost. Understanding that risk exists is the first step in combating it or taking advantage of it. Be careful out there.