2015 Third Quarter Economic Update, Bonds and Inflation

Autumn has arrived and a change is in the air. Hopefully, this will transcend to the markets, as last quarter was a rough ride for even the most seasoned investor. Volatility returned with conviction to the markets this quarter as a result of underwhelming corporate earnings, falling energy prices and economic turmoil in China and Greece. The market correction affected most sectors of the market with a sweeping brushstroke as quite a number of days saw triple digit changes and even a brief flirtation with quadruple digits one day.

It is likely that the rest of 2015 will see continued volatility in the markets. Collectively, investors are fearful about contagion from China and emerging markets. Emerging markets face significant headwinds and their struggles may negatively impact the growth in the United States and Europe. This fear has led to wild and large price swings, both up and down. In such a market environment, a disciplined investment plan and buy and hold strategy is important.

The Federal Reserve decided not to raise short-term interest rates, surprising many market watchers, who were looking forward to an end to the interventionist policies of the Fed. The Fed faces the daunting task of deciding to finally raise short-term interest rates for the first time in nearly a decade during a period of solid economic growth trends in the US coupled with global growth problems abroad. Some economists and analysts believe a rate hike this year would come at an inopportune time. Others would like the Fed to just get on with it and raise rates already. In fact, the markets seem overly prepared for such a decision and it may be a positive development for the economy and the markets.

All of this talk about rising interest rates has led to much thought and concern over bonds for the first time in many years. The rise in rates is a double-edged sword for investors. Savings accounts and short-term accounts have suffered in a low rate environment as CDs and bank accounts have yielded very little to no return for years. However, as interest rates rise, bond yields will rise as well. Ultimately, this will lead to higher yields on new bonds BUT losses on older bonds with lower yields. And thus the justified focus on bonds. I thought now might be a good time to address a few misconceptions about bonds:

  • Income is not the purpose of bonds. It is important for investors to understand that bonds are the stable value portion of the portfolio with the purpose of keeping up with inflation and taxes.
  • Market timing is not a good strategy for bonds. While some adjustments are necessary in a rising interest rate environment, major sweeping changes are not. History and s number of studies have shown that economists are horrible at predicting interest rate movements…in fact, they’ve been correct less than half of the time. So as with stocks, a disciplined long-term investment plan is the best strategy.
  • Higher rates are not terrible for bonds. As I mentioned previously, it is true that existing bonds with lower rates will lose value. New bonds will have higher rates, though, providing a better return for the buyers of those bonds. A laddered bond strategy in a portfolio or mutual fund will allow investors to keep pace with rising bond yields.
  • Individual bonds held to maturity do not eliminate interest rate risk. Quite the contrary, there is a loss in value of the fixed interest rate payments and the return of principal. The bondholder receives less money than the current market dictates and therefore, there is no protection from interest rate risk. This is the reason some investors buy individual bonds, then hold them until maturity and falsely assume they are protected.

As always, if you have any questions or wish to discuss your portfolio, please contact our office.

Warm regards,

Olivia A. Mussett, CFP®

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