Recently someone asked me the question: “Is the bond market safe in the face of rising interest rates?” and I really couldn’t answer without asking what their idea of “safe” is. In evaluating the risk involved in purchasing a particular bond in a particular sector, safe is a relative word, and can be viewed differently depending on your investment strategy and/or comfort level with market fluctuations. Conventional risks involved in bond issues include credit, liquidity and interest rate risk, and different people view these risks differently.
In late 2008, with the fall of Lehman Brothers, we saw an historical widening of credit spreads, while liquidity on even the highest-rated issues disappeared. Since then, with enormous assistance from the Federal Reserve, we have seen a dramatic recovery in both corporate credit and general market liquidity. In fact, credit spreads are back to pre-2008 levels, as companies are able to recapitalize their balance sheets and refinance their debt at historically favorable rates. By keeping short rates low through traditional Fed Funds target operations, along with longer term unconventional quantitative easing (QE) actions, the Federal Reserve essentially provided a ceiling for interest rates.
These actions by the Federal Reserve were necessary, and on the surface looked foolproof, but now have created interest rate risk unseen in this country since the mid-1980s. These risks became real in May and June of this year, when the benchmark 10-year U.S. Treasury yield leapt 100 basis points, putting a serious dent in bond prices. This after Fed Chairman Bernanke hinted that the Fed might start to reduce QE. To put the recent rate increase in perspective, if an investor purchased a 10-year Treasury with a 2% coupon when rates were at 1.65%, they would now have a market loss of 8.6% on that particular issue with rates currently at 2.65%. Many investors believe bonds (and particularly Treasuries) to be “risk free” investments as they pertain to credit and liquidity. However, there is still interest rate risk involved, which can result in negative returns.
So, is it “safe” to be in bonds at this point? Generally speaking, the answer is yes, due to a much better credit and liquidity environment. If your goal is to purchase a bond and hold it to maturity, you are still able to get a reasonable coupon, along with the confidence that principal and interest will be returned in full at maturity. However, be prepared to see some “paper losses” and market value fluctuations on your bond investments as rates rise to more normal levels.