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Why Buy Bonds If Interest Rates Will Rise?

by Hildy Richelson and Stan Richelson

Why Buy Bonds If Interest Rates Will Rise? Splash image

Many individual investors wish to buy bonds to achieve a secure cash flow and to reduce their risks in the stock market.

However, with interest rates at a low level, some investors are concerned that after they purchase bonds, interest rates will rise and their bonds will decline in value. We examine the validity of this concern, certain alternatives to bonds and our proposed solution to low interest rates.

You should not have to wait until the end of this article to get to our proposed solution to the low interest rate problem: We propose a bond ladder of individual bonds structured to take into account your financial needs and objectives. The bond ladder will finesse the possibility of rising interest rates. A bond ladder will also enhance your appreciation of the value of cash flow and power of compound interest.

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Hildy Richelson is president of Scarsdale Investment Group, a registered investment adviser based in Blue Bell, Pennsylvania, that specializes in fixed-income investments. Hildy and Stan Richelson are co-authors of several books on bonds, including “Bonds: The Unbeaten Path to Secure Investment Growth,” Second Edition (Bloomberg Press, 2011).
Stan Richelson is a representative of Scarsdale Investment Group, a registered investment adviser based in Blue Bell, Pennsylvania, that specializes in fixed-income investments. Stan and Hildy Richelson are co-authors of several books on bonds, including “Bonds: The Unbeaten Path to Secure Investment Growth,” Second Edition (Bloomberg Press, 2011).


Discussion

Walt B from New York posted 11 months ago:

This article advises using individual bonds vs bond funds. You can find a publication ("A topic of interest: Bonds or Bond Funds") on the Vanguard web site that recommends the opposite. Vanguard focuses on increased liquidity,lower transaction costs (bid-ask, wholesale vs retail) and the diversification advantages of funds. They also recognize the control advantages from individual bonds.

It sure would be nice to see some real numerical analysis. Individual bonds are an asset class as are bond funds. When calculating the efficient frontier, you can use either. What's the difference in expected return for a simple asset allocation, viz., 60:40 stock index: bond using the two different bond asset classes?


Howard... from Oregon posted 11 months ago:

I hold Oregon mutual's, in an state fund that has a fairly long duration, but covers all taxes
(Oregon tops at 9.3%) The price has increased, as well as the return. My other major holding is
in the Vanguard Hi Yield bond fund. The asset value of this fund has increased nicely, and the return, in an IRA account, defers the taxation.

OK, I am sitting on a time bomb when rates move up. I still recall the hit I took in the 90's sitting on bond funds! However as long as Uncle Ben continues the current policy game I feel ok. When I see a change afoot, I will go to cash. This is easy to do with these funds.


Lee from Maryland posted 11 months ago:

Planning on holding a ladder of longer term bonds to maturity in our old age (say 85 plus) may not work so well providing income while we are alive. I would appreciate an analysis proving feasibility of this situation or a caution against using such a ladder should be added. Over which age groups does the article's recommendations apply?


David from Vermont posted 11 months ago:

As Walt B says, it would be nice to see some numerical analysis - what does happen to a bond fund, in absolute terms, with rising interest rates and redeposited interest dividends? How does that compare to a bond ladder? And does a bond fund merely make immediate the lost interest that is hidden in a ladder? Which in dollar terms returns the more over years of up or down markets? Thank you.


skibutch. from California posted 11 months ago:

I thought this was a very informative article. When you buy a bond, your principal is protected from market fluctuation. I find this comforting in the current environment.

However, it is important to remember that even with the principal protection, you can loose a lot of valu to inflation.


MP from New York posted 11 months ago:

If for all those years the High yield bond funds were doing good, if we were to take a hit when interest rates go up, I believe we are still better off then keeping it in cash or low yielding bonds(in tax deferred account). If we are long term investors, I don't see a problem with a quality High Yield Bond Fund.


Jay from California posted 11 months ago:

Walt - Where is that Vanguard article on their site? I couldn't find it.


Jay from California posted 11 months ago:

What I don't understand about this article is that it is suggesting laddering your bonds with due dates from 15 to 23 years, while elsewhere in the article it talks about time frames of five to ten years. I don't want to lock up my money for a minimum of 15 years when interest rates may be going up in the next few years - I will want to cash out then and invest in higher-yield bonds. Also I am within about 12 years of retirement age. It would seem to make sense to invest in bonds with a maturity of from 2 to maybe 5 years, no?


Samuel Dollyhigh from South Carolina posted 11 months ago:

I agree with Jay. I was surprised to read 15 - 23 years as a recommendation. As the article states - shortening up on duration would protect against rising rates. I don't know why you wouldn't want to do this in the current environment. To me the bond ladder should start somewhere between 2 and 5 years and then extend from there to longer duration bonds.


hildy from Pennsylvania posted 11 months ago:

We recommend bonds in the 15 to 23 year range because that is where the yield is. That is the same reason Willy Sutton gave when he asked why he robbed banks. "That is where the money is." he replied. If the Fed starts to raise short-term interest rates, then our recommendation would probably change. However, if you want some yield 2 to 5 year maturities just doesn't do it! 5-year Treasuries are currently paying 0.83% taxable, while double-A rated munis are paying 0.99%. 20 year munis with the same rating are paying better than 3% currently, federal, state and maybe local tax-free.


SJ from New York posted 11 months ago:

Buying individual bonds seems to be the way to go, but there is enough literature out there that says that it is not for the retail investor. Unlike stocks, the bond market is not very liquid and that one could get squashed by the bid-ask spread. Few articles seem to address this issue. Of course, if one directly buys from the Treasury, one avoids this problem, but for corporates and municipals one has deal with the spread. I have also noticed the lack of articles, even in the AAII, about how to intelligently go about buying bonds.


Hildy from Pennsylvania posted 10 months ago:

The problem with high yield bond funds is that there has been such demand for yield that the spreads between the high yield bonds and investment grade bonds have narrowed. You can expect the spreads to widen as interest rates on higher quality bonds improve and more pressure is put on the strained resources of the issuers of those high yield bonds.

For a bond investor, rising interest rates are the upside case if you can reinvest the interest payments into higher yielding bonds. It is like income averaging up for stock investors.

SJ Please read about buying individual bonds in our book: BONDS: The Unbeaten Path to Secure Investment Growth, 2011 - second edition.

Thank you for your remarks, David.

Lee, losses are not hidden in the ladder because the bonds ultimately come due at face value. The bond funds never come due. This is why bond funds use the concept of modified duration, which is the amount of time it takes to get interest and principal back. Each year implies a 1% change in the price when or if interest rates go up or down 100 basis points.

Thank you for your comments.


Ian from Pennsylvania posted 10 months ago:

This was a very interesting article. I also think that an alternative ladder could be built with some of the new defined maturity ETFs currently offered by iShares and Guggenheim. I wonder if anyone else has any thoughts or experience with these.


Charles Rotblut from Illinois posted 10 months ago:

Hi Ian,

I'm starting to look into defined maturity funds for a future AAII Journal article.

-Charles Rotblut


Bernie Tarango from California posted 10 months ago:

This is a very one sided article.... there is no mention of transaction costs ( especially with the low amount 100K of investment). Also, there is also the risk of loss ( even with high quality) that are not factored. Very disappointed in the analysis and presentation of facts.....


Harry from Pennsylvania posted 10 months ago:

A couple of quick points.
Willie Sutton never said that, but did use it for the title of a book.
If you can't find an article at a web site, for ex. Vanguard, use Google. Google's search is better at finding articles anywhere on the web than VG's search is for just its own web site.
For me the argument that a bond doesn't lose value but a bond mutual fund does is equivalent to sticking your head in the sand. If a I bought a bond yesterday and put it in my safe deposit box, it's easy to ignore the fact that I just "lost" money today because rates went up.
But if you don't sell then you don't lose anything either way.


James Pier from Ohio posted 10 months ago:

There's a reason Warren Buffett's asset allocation advice is a whole lot different than 100% bonds.

1. The Richelsons' advice is clearly biased, and AAII owes it to its membership to publish that caveat. If one's entire advisory business is built on advising investors to invest in bonds, not to mention selling books with that advice, then one is not about to come out and say that bonds are the wrong place to be, or even relatively high risk in the current environment.

2. The long-term average returns for stocks and bonds and other asset classes are interesting, but certainly not dispositive in making decisions. One must consider each alternative at the then available market price. Buying high, even if one doesn't intend to sell low, can only lead to lower-than-average returns over time. As the authors rightly point out, one difference between bonds and stocks is that bond prices tell you right up front what the held-to-maturity return will be. Bonds are currently so close to their ALL-TIME highs as to make their purchase at least very questionable. Find a long-term chart of bond prices and see for yourself--buying now looks crazy. In hindsight, buying stocks in late 1999 was a bad idea, but it sure was easy to feel smart doing it then.

It makes no difference that "nobody knows when rates will go up." The fact is that yields are very low--inadequate to build wealth and dangerous vis a vis maintaining wealth while drawing income. Unless one is already quite wealthy, 100% bonds is as sure a loser as one can find among the various asset classes. It is not a question of whether bond prices will fall, only when, how much, and how fast.

3. What difference does it really make if I ladder my portfolio? Suppose I hold 10 bond positions of laddered maturity, and one of them comes due during a higher-rate environment. I can reinvest 10% of my portfolio at a higher rate. Oh good. The other 90% I hold at a loss, whether I want to sell them or not, and I continue to suffer with their dismal yields. Building a bond ladder of 15-23 year duration today means locking in low returns on most of your portfolio for an awfully long time.


Hildy Richelson from Pennsylvania posted 9 months ago:

Dear Mr. Pier,

We cannot foresee the future and therefore cannot advise our clients to try one investing alternative rather than another based on prospective outcomes. What we suggest is a low cost strategy that has fairly predictable outcomes. We do not say that it is perfect, nor do we say that this is the solution for every investor.

For high net worth individuals, and investors who follow the credo "Slow and steady wins the race," investing in high quality individual bonds creates a predictable stream of income. As interest rates rise, they can reinvest the income into higher yielding bonds.

I don't know about you, but I prefer to reinvest at higher interest rates. Waiting until they rise has its own costs, as many investors found. They created five year, short-term bond ladders yielding nothing because they knew that interest rates would soon rise. They lost the opportunity to have the interest payments compound - the basis of growth in bond investing.

Stock market investors required extraordinary staying power to wait more than ten years until stock prices picked up. Long term stock investors saw volatility for many years, but it was not until 2012 that the stock market finally rose above the March of 2000 high.

There is no perfect advice for anyone. Each of us has to weigh the information and then chose the best path. Investing in high quality bonds provides greater predictability, and some investors may chose that despite the downsides.


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