Five steps to get your clients out of bonds and into alternative, low-volatility investments
What will prompt the next emotional reaction from investors? Falling bond rates and rising stocks.
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It is important to make a key distinction between individual bonds and bond funds. Bonds are legal obligations to pay a specific coupon payment and return a known principal amount at maturity. Investors can control their downside with the looming concerns of rising rates by simply holding bonds to maturity. The yield will be positive and the paper losses are never realized. Investors simply get their money back. Returns are completely predictable from the day investors purchase their bonds. YTM is the worst case and it is positive.
Bond funds, on the other hand, are mutual funds that happen to own bonds. There is no principal protection. When rates rise, bond funds lose money. Average turnover in taxable high quality bond funds is 150% per year, meaning that the fund does not hold bonds to maturity and therefore will experience losses as rates rise. These losses are not paper losses, they are realized losses. Permanent.
In this environment, individual bonds provide protection of principal that other asset classes cannot provide. Low volatility just means they will likely lose less when conditions are bad. It doesn’t mean that low volatility asset classes are bad. In fact they can play an important role in a portfolio. Investors need to recognize that at current low rates, principal protection is expensive and that low volatilty assets can still lose money. Challenging times to be an income investor.