Archimedes on Those Bonds in Your Portfolio

The past year saw a handful of faux crises pop up in the financial markets. There is at least one thing I legitimately worry about for investors in 2011, however: bonds in their portfolios.

Since the equity market has got beaten up over the last 10 year period, for a few years now many individual investors began buying into bond funds to eke out at least a smidge of a return – something more stable than the stock market, but higher than bank rates. The largest bond fund out there, PIMCO Total Return Fund, has seen positive inflows for two years.

Why worry about this? Because, in short, I’m not sure most investors see the dangers of owning bonds. PIMCO Total Return, for instance, is one of the only bond funds offered in many 401(k) plans. So, while hard to quantify, I think it’s safe to say that particular fund may be where a lot of folks have put their money over the last decade.

The danger? As the Greek physicist Archimedes said, “Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.”

A fundamental law of finance is that bond prices and yields move in opposite directions. If the Federal Reserve’s latest Quantitative Easing (QE) efforts are successful, the economic recovery will accelerate, and interest rates will rise (since the price of money increases to reflect more demand). New bonds issued post-QE will have to pay higher interest rates to attract investors. Since the vast majority of fixed income investors do not holding their bonds to maturity, once interest rates rise, many will then sell current bond holdings to buy newer, higher yielding bonds. This will lead to a decline in the prices of existing bonds – particularly in those bonds with the longest remaining time to maturity, or “long bonds.”

Now, all that said, even if you have zero knowledge of finance, if I told you interest rates are near historic lows, what would be your guess regarding what interest rates will do next? Right – which is where Archimedes comes in: with rates at such lows, the bond market is a very big lever indeed. Just a small movement in interest rates can bring bond prices down quite hard, and longer-term bonds could be driven into the ground. Shorter-term bond mutual funds should have a softer landing but will still drop.

PIMCO Total Return Fund has a duration of almost 5 years. Is that short enough to protect investors’ portfolios when rates go up? I’m not so sure. One good piece of news, however, is that the end of 2010 saw the first month of net redemptions from that PIMCO fund. So, here’s to hoping other investors realize the bond market may not be such a safe place after all.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.
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