Are Your Bonds Safe?

 

 

 

 

 

 

Jane M. Young

Let’s compare some differences between stocks and bonds.  When you buy a bond you are essentially lending money to a corporation or government entity for a set period of time in exchange for a specified rate of interest.  When you invest in the stock market you assume an ownership position in the company whose stock you are purchasing.  As a result, the value of your investment will fluctuate based on the profit or loss of the underlying company.  With the purchase of a bond the value of your investment hould not fluctuate based on the financial performance of the issuer, assuming it remains solvent.  You will continue to receive interest payments according to the original terms of the agreement until the bond matures.  Upon maturity the amount of your original investment (principal) will be returned to you along with any interest that is due.   As a general rule, stocks are inherently more risky than bonds, therefore investors expect to receive a higher return.

Bonds may appear to be safe but they are not without risk. Currently, there is some risk associated with low interest rates that may not keep up with inflation.  This is especially true with many government bonds. Two additional risks typically associated with bonds include default risk and interest rate risk.

Default risk is the risk that the issuer goes bankrupt and is unable to return your principal.  Most bond issuers are assigned a rating to help investors assess the potential default risk of a bond.   Generally, investors are compensated with higher interest rates when taking a risk on lower rated bonds and receive lower interest rates on higher rated bonds.

Interest rate risk is based on the inverse relationship between interest rates and the value of a bond.  When interest rates increase the value of a bond will decrease and when interest rates decrease the value of a bond will increase. If you hold an individual bond until maturity your entire principal should be returned to you.  You have the control to keep the bond until maturity and avoid a loss.  However, if you need to sell before maturity you may lose some principal. The loss of principal is greater for longer term bonds.  This needs to be weighed against the benefit of a higher interest rate paid on longer term bonds.

Bond mutual funds can provide diversification and reduced default risk because your money is pooled with hundreds of other investors and invested in bonds from a large number of different entities.  If one or two entities within the mutual fund go bankrupt there will be minimal impact on each individual investor.  However, with mutual funds you have less control over interest rate risk.  When interest rates increase, bond fund managers often experience a high rate of withdrawals forcing them to sell bonds at an inopportune time.  This usually results in a loss of principal, the severity of which is greater for longer term bond funds.

Stay The Course! Ten Steps to Help You Through Uncertain Financial Times

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Jane M. Young, CFP, EA

1. Don’t react emotionally! This will result in a constant cycle of buying high and selling low. Once you sell, you lock in your losses. Stay the course and focus on what you can control.

2. Make sure you have an emergency fund of three to six months of expenses.

3. Evaluate your asset allocation to be sure it is consistent with the timeframe in which you need to withdraw money. The stock market is a long term investment; you should never have short term money in the stock market. Make adjustments to your allocation based on your long term goals and need for liquidity not on fear.

4. Maintain a well diversified portfolio.

5. Pay-off credit cards and high interest consumer debt. Be wary of variable rate loans, lines of credit and mortgages. The downgrade in the U.S. credit rating could hasten an increase in interest rates.

6. Get your personal finances in order. It’s always a good idea to understand your spending and keep expenses in line with your income and financial goals. This is a good time to tighten your belt to be prepared for unexpected emergencies.

7. Use dollar cost averaging to invest new money into the stock market. Volatility in the stock market creates great buying opportunities.

8. Don’t get caught up in the media hype. They are in the business to sell newspapers, magazines and television commercials. Avoid the new hot asset class they are trying to promote this week. Sound investment advice is boring and doesn’t sell newspapers.

9. Take steps to secure or improve your income stream. Are you performing up to speed at work? Are you getting along with co-workers? Should you take some classes to keep your skills current? Are you underemployed or under paid for your education and experience? Consider a second job to pay down excess debt.

10. Stay calm, be patient and focus on making sure your financial plan meets your long term goals and objectives. Stay the course, this too shall pass.

Solve the Deficit Problem by Cutting Government Spending – You Don’t Stop the Spending by Refusing to Increase the Debt Ceiling

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Jane M. Young, CFP, EA

A few clients and friends have asked me if they should be making changes to their investment allocations based on the uncertainty around raising the debt ceiling. While we don’t want to bury our heads in the sand we should not over react to something that probably won’t come to pass. In my opinion the political stakes are way too high for all parties concerned to allow the U.S. to default on its obligations. At the moment everyone is playing chicken but at the end of the day, neither party can afford the political fallout that would result in a failure to raise the debt ceiling. This does present a great opportunity for the media to get attention with sensationalistic, doomsday headlines to help them sell newspapers or television spots. This is also a great opportunity for political posturing on the part of both Democrats and Republicans. It is my projection that on August 2nd we will still have a huge deficit problem and a higher debt ceiling.

The debt ceiling is an indication of a much bigger problem with federal government spending. The problem is not solved by changing the debt ceiling; the problem was created when congress approved spending resulting in the need to raise the debt ceiling. Failure to raise the debt ceiling is like trying to close the barn door after the horse has gotten out. Refusing to raise the debt ceiling is a meaningless gesture, with regard to our deficit. However, it carries a catastrophic impact on the perceived safety of U.S. debt which would ripple down through all aspects of our financial lives. This is clearly not an acceptable course of action. The real issue is getting a handle on government spending and the deficit which will require major reforms to Social Security and Medicare. Our economy and prosperity are being held back by a looming black cloud caused by fear and uncertainty with regard government spending and the federal deficit.

New Normal

By Bert Whitehead, MBA, JD

A number of clients have expressed alarm at the recent clamor of commentators who have been predicting a cataclysmic economic change worldwide. These pundits claim that we are facing an economic “New Normal” and express concern that the ‘old’ economic rules on which we rely no longer operate.

Their conclusions? Drastic changes are needed in our lives and investments to accommodate the “New Normal!”

Usually they question the viability of the U.S. dollar and offer the possibility that China, or perhaps a block of other nations, are somehow positioned to ‘take over’ the U.S. because they hold so many U.S. bonds. Another variation of this calamity centers on the recent collapse of the real estate market, the precipitous drop in the stock market, and extraordinarily low interest rates. Taken together, these developments presage the end of American prosperity for our children and ourselves.

Of course these apocalyptic pronouncements are more effective if they are tied to some political viewpoint, the more extreme the better. More often than not, far right political viewpoints proclaim that doomsday is the certain result of left-wing politics. Leftist views generally emphasize the inevitable revolution that suppression of the masses will cause.

(Note to “Investment Advice” file: Never let your politics drive your investments!)

It’s time to confront these ridiculous assertions. Yes, it is true that the investment and economic travails of the past decade have been severe and have impacted many people worldwide. Some of these changes have not occurred before during many of our lifetimes. It is enticing to point the finger of blame and shame at our financial, economic, investment and political leadership. But that is not the whole story
The power of momentum in democratic economies is easily underestimated. Although dramatic from time to time, the impact of severe financial shifts must be kept in proportion and viewed within a broader historical perspective. We need to recognize that most extreme economic shifts are self-correcting.

Even with unemployment at over 9%, over 90% of our citizens are employed. Real estate crashes, weather-related disasters, stock market crashes, low interest rates, etc. have all happened before. Indeed the damage done by seismic economic shifts during the Great Depression, the severe stagflation in the 1970’s, and the collapse of S. & L.’s in the 1980’s were all worse than we have seen today…and all of these are relatively minor when compared to the disruption of the financial markets in the 19th century. And whatever happened to the “New Economy” theory that gave rise to the ‘dot-com’ frenzy of the 1990’s?

It is folly to fret about how much of our debt is owned by the China (interestingly, Japan owns nearly as much U.S. debt as China, even though that fact is not usually noted). What can the Chinese do with our debt? They can’t dump it on the White House lawn and demand to be paid off with gold. They can’t go on the world markets and exchange dollars for Euros or Yen, or even buy gold. Any of these moves would be self-defeating because dumping huge amounts of money in any market would decrease the value of their remaining dollars. Actually, their only realistic option is to spend it in the U.S.!

There is a concern that the U.S. dollar is at a “tipping point” and will soon lose its status as the world’s reserve currency. But no other currency is in a position to take its place. The Euro’s stability is much too questionable. The Yuan doesn’t have a long enough history to be relied upon, especially when a dictatorial government can arbitrarily determine its value. Neither these nor other ‘respectable’ currencies such as the Yen, the British Pound, the Swiss Franc, etc. have enough depth to support a global economy.

Those who espouse extreme economic outcomes are invariably selling something. Usually it is their newsletter or book, or some strategy to beat the market, or gold itself. The most eminent economists in the world have never been able to predict any economic cycle with a meaningful consensus. Why should you believe the extreme voices of charlatans who use their advanced marketing techniques to dupe the fearful?

What can you do? I suggest that you sit back and follow sensible advice. The Functional Asset Allocation model, which is used by nearly 200 fee-only members of ACA (Alliance of Cambridge Advisors), focuses on the basics.

Consider this…there are only three possible economic scenarios: we can have inflation, deflation, or prosperity. It is a waste of time to try to determine which is coming next. The prudent approach is to be prepared for all three possibilities. As the ancient wisdom of the Torah exhorts: “Invest a third in land, a third in business, and a third in reserves!”

Today, that translates into a balanced portfolio of real estate, equities (i.e. stocks in companies), and cash and bond reserves. Trying to market-time and pick the next ‘hot investment’ is foolhardy. If you allow the vagaries of global economics, i.e. exogenous factors, to be the focus of your attention, you risk making decisions based on emotion rather than rational thought. In truth, it is the ‘endogenous factors’ in your life that determine your financial future.

As Pogo once said, “We have met the enemy, and he is us!” Instead of dithering about what will happen in the Mideast, or where interest rates are headed, or when will real estate level off, look at the things in your life that make a difference. Are you saving at least 10% of your gross income? Are you living within your means? Do you have enough liquidity to ride out a financial setback? Do you have a long-term fixed rate mortgage to protect you from inflation? Do you have government bonds to weather another bout of deflation.

Obsessing about the various complexities and possible outcomes in today’s global economy inevitably leads to rash and unwise leaps. Keep an eye on the issues within your reach! It is the key to a confident journey and a serene financial future.

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.

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