Nearly every
conversation about the investment marketplace focuses on the stock market. From the media to financial advisors to
investors, the bond market has long been an overlooked wallflower at the
proverbial investment dance, even though it has experienced exceptional
risk-adjusted returns over many years.
However, the bond
market is currently the one that deserves attention. After a decades-long run of falling interest
rates (and thus bond prices rising), bond yields recently have risen sharply, negatively impacting those portfolios with significant exposure to what
many consider a ‘safe’ investment.
Generally speaking,
the bond market works like this: As demand
rises for less risky investments, bond prices go up. If you are a bond issuer, such as a
government or a corporation, heavy demand means you can get away with paying a
lower yield. Borrowing gets cheaper,
with a hoped-for side effect of economic stimulation.
After the 2008
financial panic, bond prices rose to a great degree because the U.S. Federal
Reserve started buying billions of dollars of government-issued debt. Without this central bank action, demand
surely would fall, and issuers would be forced to pay higher rates, potentially
stifling an economic recovery.
In the past several months, uncertainty about when the Fed might taper its purchases caused a broad
selloff in bonds. Yields climbed
rapidly, and fixed income investors suffered losses. Note that nothing actually changed; rather, the
bond market reacted in a volatile way to the mere perception of a change.
No one knows exactly
when the Fed will decrease its government bond purchases, but fortunately, we
don’t have to know to have a good investment outcome. A successful investment portfolio doesn’t
come from market timing – it comes from a low-cost, risk-appropriate mix of
stocks and bonds based on time horizon, with disciplined rebalancing to that
mix as necessary.
Managing bond risk
is no different than managing stock risk, in the sense that emotion-free
decision-making is critical. The bond market wallflower may
suddenly want more attention, but that doesn’t mean you have to change how you dance.
