Rates are rising! Buy bonds?
The Federal Reserve raised interest rates in December and they might do it again in 2016. When interest rates rise bond prices fall. The relationship is like a see-saw in a park when one side is up the other side is down. If interest rates are going to rise, why would you want to buy bonds?
It’s true a rate rise will cause disruption in prices. It’s in this disturbance where a bond buyer can find opportunity.
Let’s look at some numbers. The thirty-year U.S. Treasury Bond is currently paying 2.64 percent. A one percent rise in interest rates will mean an 18 percent loss in the value of this bond. The bond price will fall from $100 to $81.92. A buyer of this bond at $81.92 will have the opportunity to make 22 percent when it matures to $100. In addition, the current income has jumped from 2.64 percent to 3.22 percent by buying this bond at $81.92.
Since 1926 the U.S. T-Bill has generated an average annual return of 3.4 percent while the long term government bond has averaged 5.6 percent.
Bond funds are considered lousy investments when interest rates rise. However, it’s assumed, incorrectly, that the fund manager is doing nothing with their portfolio during a rising rate environment. In a rising rate scenario, the fund manager is buying bonds at lower prices while locking in higher rates. Lower bond prices and higher coupons will benefit all shareholders at some point.
One of the oldest bond mutual funds is the Franklin U.S. Government Securities Fund (FKUSX). This fund originated in May of 1970 and since inception it has delivered an average annual total return of 6.26 percent. The best year was 1982 returning 33.04 percent to shareholders. The worst year was 1980 generating a loss of 12.87 percent. A $100,000 investment in May of 1970 is now worth $1,624,990.
When rates rise the first reaction for bond holders is to sell. When bond holders sell this creates a buying opportunity for individuals with a long term view. A buyer can take advantage of panic sells by buying bonds at favorable prices. Their pain will be your gain.
Better Total Return.
Don’t fear the rate rise. It will treat you well in the long run.
“The Chinese use two brush strokes to write the word 'crisis.' One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger--but recognize the opportunity.” John F. Kennedy.
Bill Parrott is the President and CEO of Parrott Wealth Management, LLC. www. Parrottwealth.com.
May 26, 2016
 Dimensional Fund Matrix Book 2016, pages 42 & 44.
 Morningstar Office® Online Hypothetical Tool.