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Answering Your Questions on Bonds

Christine Benz
Eric Jacobson

Christine Benz: Hi. I am Christine Benz for We received lots of great questions in advance of our recent retirement readiness webinar. Many of them related to bonds. To help us answer them with thought we'd go straight to the source and check in with Eric Jacobson. He is a senior fund analyst at Morningstar, and he specializes in bonds and bond funds.

Eric, thank you so much for being here.

Eric Jacobson: I'm really glad to be with you Christine.

Benz: Eric, I would like to just start with a question of my own about the current interest-rate environment. So the Federal Reserve is saying that it's going to keep rates way, way down for the foreseeable future. What does that mean in terms of how investors should manage their interest-rate sensitivity [also known as duration]? Are they free venture into long-duration bonds because the Fed is saying it plans to keep rates nice and low? How should they interpret that statement from the Fed?

Jacobson: Well, the most tricky thing about it, Christine, is that they have different places on the yield curve or the maturity spectrum that they can operate. And when the Fed talk about keeping short rates low, which is really what they're saying, that's a place where you can pretty much rely on what they're saying, although I have talked to managers who don't believe, for example, that the Fed will keep them at rock bottom as long as they say they are. But let's just say, for example, for the sake of argument that you can take the Fed at their word. The bigger issue is how much longer they're going to continue to suppress long-term rates. And if you've heard a lot about QE2, QE3 in the news, that's what I'm talking about there. Those are cases in which they have purchased very long--well, not necessarily very long maturity bonds, in the case of mortgages they are not, they have long nominal maturities, but they don't tend to last as long as 30 years because of the fact that principal is getting paid down--but in any case, those purchases right now are suppressing longer-term rates.

And even though the Fed says they are going to continue with this latest QE3 round to buy longer-maturity bonds, it's a little bit hard to know how long that's going to take effect for or how long it's going to remain in effect and whether or not it will continue to have the same effect that it's having now, which is to suppress long-term yields. I think there are quite a few managers for example who worry that longer-term rates could see an upward trend at some point in the reasonably near future even if the Fed is keeping short-term rates so deeply suppressed.

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Benz: So, you would want to be careful about venturing into longer-duration bonds even though the Fed's stated policy is to keep at least rates low for the near term?

Jacobson: That's the hard question because the biggest threat to long-term bonds is really inflation. To some degree you could argue it's a supply/demand thing. If the Fed stops buying, that in and of itself could allow rates to rise. But if inflation doesn't pick up and growth doesn't really get going, it's hard to say that rates are going to rise at the long end. It's just a huge risk right now it seems like, but we don't really know where things are going. That argues in favor of some care, absolutely, but I don't want to necessarily go on record saying that they're going to rise in the near future because we've been fooled numerous times before up until now.

Benz: Let's venture into the reader questions. The first one, and I think it's one that is top-of-mind for a lot of investors, how do you know when to get out of bond funds as interest rates rise? So, the concern is, as rates rise my bond funds' holdings are maybe worth less because they have lower coupons attached to them. How do you tackle a question like that Eric?

Jacobson: Well, you know what, if I could answer that question with any amount of certainty I could retire tomorrow and move out onto the beach. Unfortunately, it's something that none of us really know for sure. And if you look, for example, what a lot of managers are doing, they don't know either, and they're trying to be cautious. But as I said earlier, we've been fooled before by trends in the market, and we went a whole year last year were rates were falling at a time when a lot of managers thought they were rising.

You are tending to see a little bit more agreement now that the risk is higher for rates rising, and that's a case where you don't necessarily want to wait it out and try to time it perfectly because you can, as we often say, get whipsawed or you can get on the wrong side of that trade and get really badly hurt. And if you go short too soon, of course, you give up some opportunity cost, but that seems to be where the prevailing wisdom is going at this point.

Benz: Another related question on this list is why not just hold cash instead of bonds? Forget bonds with this uncertainty and just hunker down in cash instead. What do you say to someone who poses that question?

Jacobson: I'd say it's extremely tempting right now, especially given the low yields on bonds. The difficulty, the risk that you run with holding cash is that what we call the real yield on cash is negative right now. In other words, the purchasing power that you have with cash is eroding because the level of inflation is positive, and you're most likely not earning anywhere near that much in cash right now. So, yeah if you do that for three or six months and you wait it out and see if rates rise, you could be lucky enough to time it correctly. But as I said before, if rates don't rise and you continue going along a year or more and you're in cash, you're losing purchasing power all the along way.

Benz: Another question related to bonds and interest-rate sensitivity from one of our users, the question is: What bond duration is reasonably safe and wise in a time when interest rates will be rising?

Jacobson: Well, I wish I could give a deterministic answer to that one, as well, but I can't. I will say that you can sort of ratchet it down mentally and get to the point where you say, "OK. Well, what about two years or three years?" At that point, what you're saying is, if rates move up a 100 basis points in a very short period of time, or 1 full percentage point, you would lose 2% to 3%. If they jumped 200 basis points, or 2 percentage points, you multiply that by the duration, so two or three years, and you get either 4 or 6 percentage points of loss.

If you think you can handle that over a reasonably short period time and are willing to wait it out after the fact and make that money back over the next year or two, you are going to probably be in decent shape. Short-duration bonds tend not to fall as much, clearly, and it's easier to earn those losses back over time, but if you can't take that heat you have got to go lower and you got to get close to zero.

Benz: One last question, Eric, is: Are lower-quality bond funds maybe a better bet at this juncture than longer-duration bonds?

Jacobson: It's tough because a lot of managers believe that's the case right now. The hard part is, knowing whether or not the valuations are too tight because what we've seen as the Fed has been encouraging people by keeping high-quality rates so low is money moving and migrating into higher-yielding things like bank loans, emerging markets, and high yield, those are categories that are all doing well this year. The problem again, as I said, is are valuations getting too tight? At some point you can get to the level where they're so tight and close to Treasuries relatively speaking, that they since start to take on some interest-rate risk and if we do have a rate spike you could get hurt.

Now, the thing about it is, is that, if you look at a sort of a classic outcome, which sort of like 1994 for example, where you have rising interest rates and a glowing economy, if we face that then high-yield bonds will do OK. They might turn out kind of flat, but you might at least get to keep the coupon if the price falls a little bit with rising interest rates. The danger that we're facing now that a lot of people are worried about, though, is that we could have rising interest rates with very sort of low, plodding growth. And in that kind of case, it's hard to say how well or how poorly high-yield bonds would do, but not nearly as well as we would hope in such a scenario.

Benz: Well, Eric, thank you so much for sharing your insights. I know these are very important questions for anyone who has bonds or bond funds in their portfolio. So, we appreciate you sharing your insights.

Jacobson: Well, I am certainly glad to be with you, Christine. Thank you.

Benz: Thanks for watching. I am Christine Benz for