Creative Planning

BOND BUBBLE?
Wealth management UPDATE February 19th, 2013
Peter Mallouk, J.D., MBA, CFP Chief Investment Officer www.thinkingbeyond.com

Bonds have had a heck of a run over the last 30 years as interest rates have steadily declined. Is the party over? And if so, what is an investor to do? First, lets cover how bonds work, and why the party very likely is over, at least for certain parts of the bond market. Bonds are simply loans. A treasury bond is a loan to the federal government, a municipal bond is a loan to a municipality like a city or state, a foreign bond is a loan to a foreign government or corporation in another country, a corporate bond is a loan to a corporation like Microsoft or Nike, and a high yield bond (often referred to as a junk bond) is a loan to an entity struggling and paying high interest, like a corporation that is financially in trouble. There are two main factors, out of many factors, that impact the interest the borrower (lets say a company) will pay a lender (lets say thats you). The first factor is credit quality. If a company is completely solid, it will likely pay lower interest. If a corporation is financially unstable, it will pay higher interest. For example, Microsoft will pay low interest, because the odds it will be able to make its loan payments are very high, while a start up company or a company losing money would pay higher interest. All else being equal, the higher the risk, the higher the interest you will receive as an investor. The second important factor is the length of the loan. If you loan money to the federal
3400 College Boulevard Leawood, KS 66211 913-338-2727 Fax 913-338-4507 Website: www.thinkingbeyond.com E-mail: cpi@thinkingbeyond.com

Creative Planning

Bond bubble?
government for 30 years, you will get a higher interest rate payment than if you loan money to the federal government for 10 years. All else being equal, the longer the loan, the higher the interest. The reason is simple: If you tie up your money for 30 years, you are taking more risk than if you tie up your money for 10 years. The risk is interest rate risk, or the risk that inflation grows and new bonds will come out at higher rates, leaving you stuck with a lower yielding bond. Now, back to the bond bubble thing. As the economy grew weaker and weaker, the Federal Reserve kept lowering interest rates to stimulate the economy. The idea is that if rates are lower, people are more likely to borrow to hire employees and buy things like equipment, homes and cars. All of this would stimulate the economy, unemployment would drop, then rates would be allowed to increase again. Well, lets look at where we are in that master plan: 1. The economy became weaker. 2. The Federal Reserve kept lowering rates. 3. People started hiring more and bought more equipment, homes and cars. 4. The Federal Reserve allowed rates to increase. Not yet! The reason the Fed hasnt raised rates yet is because while unemployment is dropping, it is not dropping quickly, nor has it returned to acceptable levels. Until then, the Federal Reserve has indicated it will keep rates low.

Wealth management UPDATE February 19th, 2013

To give you an idea as to the damage that can be caused by rising rates, a 30 year bond can lose 10% of its value for every 1% increase in interest rates.

Those who expect another recession, or even depression, continue to buy long term bonds paying a few percentage points, wagering that two or three percent is better than zero or even negative returns from other assets like stocks. Those who expect the economy to recover slowly or quickly are selling or avoiding long term bonds. The reason is that longer term bonds react negatively to rising rates.

Lets say that today you purchase a long term bond paying 3% for $1,000. Lets assume interest rates go up 1% next year. If you want to sell your 3% bond, who is going to buy it? The answer is that no one will buy it for $1,000 because they would rather buy the new 4% bonds. For you to sell it, you would need to sell it at a discount so that the return to the investor is 4%. To give you an idea as to the damage that can be caused by rising rates, a 30 year bond can lose 10% of its value for every 1% increase in interest rates. This is why those who are purchasing long term bonds today
3400 College Boulevard Leawood, KS 66211 913-338-2727 Fax 913-338-4507 Website: www.thinkingbeyond.com E-mail: cpi@thinkingbeyond.com

Creative Planning

Bond bubble?
need to be aware of interest rate risk, which today is the greatest risk facing a bond investor. If you own or are purchasing long term bonds thinking they are safe, think again. There are recent reports of a major brokerage house reclassifying bond holders as aggressive investors, probably to protect themselves from litigation if bonds get hit hard. In fact, it is possible that the 30 year U.S. treasury bond is the single worst investment available today. The current yield is actually lower than the inflation rate. Basically, in terms of purchasing power, by buying a 30 year U.S. treasury bond you are paying the government to hold the money for you. We know that any time an asset class trades far above its historical average, it returns to earth, and often in a very ugly and spectacular fashion. For recent examples, see the internet bubble or real estate bubble. Interest rates are currently far below their Those who are purchasing historical average and will eventually return to the long term bonds today mean. When they do, bonds prices will revert as well, need to be aware of and to do that, they must come way down. Well then, why dont we sell all the bonds and buy stocks or something else? The answer is that stocks, real estate, commodities, and alternative investments can all go down substantially at any time and for any or no reason. For most investors, it is not acceptable to have an entire portfolio positioned to sustain such large short term hits, and for almost all, it is not in line with their goals and objectives. That leaves us with the options of owning cash or looking at bonds differently. At Creative, we have never viewed cash as a prudent investment as it pays nothing and guarantees the investor a negative real return on their money as they lose purchasing power over time. We do however want to have an allocation in most clients portfolios to a position that can meet immediate to intermediate term needs, never leave the client at the mercy of a bear market, and provide capital to invest in stocks, real estate, commodities and alternative investments when they get hit hard in a correction or bear market. For this reason, we hold bonds, but we focus on short to intermediate term bonds. By loaning money to governments and corporations for 1 to 10 years instead of 11 to 30 years, we are accepting a slightly lower current yield on the bonds. However, by doing so we dramatically lower the interest rate risk. For example, if an investor holds a bond fund where the average bond matures in 5 years, as interest rates rise some of the bonds are redeemed and replaced with new higher yielding bonds. Within 5 years, the entire bond portfolio is replaced with new higher yielding bonds. Short to intermediate bond funds, while they can get lower returns, and sometimes even have modest negative returns if interest rates rise quickly, actually perform better over the long
3400 College Boulevard Leawood, KS 66211 913-338-2727 Fax 913-338-4507 Website: www.thinkingbeyond.com E-mail: cpi@thinkingbeyond.com

Wealth management UPDATE February 19th, 2013

interest rate risk, which today is the greatest risk facing a bond investor.

Creative Planning

Bond bubble?
run if rates rise. This is because it doesnt take too many years for the entire bond portfolio to be replaced with higher yielding bonds. Wealth management UPDATE February 19th, 2013 There are risks with every asset class and bonds are no exception. At Creative, we do expect rates to increase over time, our bond positions account for that expectation, and we will continue to closely monitor the interest rate environment, and its impact on your portfolio.

CREATIVE PLANNING Private wealth management

Barrons Top 100 Independent Financial Advisors in America. (featured at #4) Worths Top 100 Wealth Advisors in America. Boomer Market Advisor Magazine - #1 Advisor in America for Baby Boomers. Wealth Managers Top Wealth Managers in America. Medical Economics Top 150 Financial Advisors for Physicians. Financial Advisor Top 10 RIAs Forbes Top 50 Advisors in America.

Please visit our website at www.thinkingbeyond.com. Thank you for the introductions to your friends and colleagues, and for your continued confidence. Our clients are always welcome to forward our articles to family, friends and colleagues. However, it has come to our attention that some of our articles have been plagiarized. Please note: the articles are the property of Creative Planning, Inc. Reproduction in whole or in part is prohibited.

3400 College Boulevard Leawood, KS 66211 913-338-2727 Fax 913-338-4507 Website: www.thinkingbeyond.com E-mail: cpi@thinkingbeyond.com