How to Handle the Bond-Market Collapse

Most investors believe that the major source of risk in their investment portfolio comes from stocks. But as millions of people are about to find out as they open their quarterly statements early next month, the usually sleepy world of bonds has been a lot riskier recently.

Worried investors increasingly want to know what they should do about the surprising losses from the supposedly "safe" portion of their portfolios.

Traditionally, investors allocate their money between stocks and bonds. Stocks have more growth potential, as their value is tied to the fundamental prospects of a company's business. As earnings grow, so too do share prices, at least over long periods of time.

By contrast, bonds represent IOUs from companies to investors, with bondholders entitled only to repayment of their principal when the bond matures. That puts an upper limit on the amount of price appreciation bonds can enjoy.

Why Are Bonds Falling?
Bond prices are tied to interest rates, with rising rates causing the value of existing bonds to fall. In a rising interest rate market, investors can purchase new bonds that offer more income, so buyers aren't willing to pay as much as they did when prevailing market rates were lower. Falling prices in turn make a bond's yield rise, bringing it in line with interest rates in the market.

For example: if a one-year bond paying 2 percent sees its price fall from $1,000 to $990, then its yield rises to about 3 percent -- the 2 percent from the income the bond pays, plus the 1 percent difference between its current price of $990 and the $1,000 that the bondholder will get at maturity.

Interest rates spiked recently because the Federal Reserve suggested that it would slow down its bond-buying program. With the Fed having bought bonds at a pace of more than $1 trillion per year, supply and demand kept bond prices high and interest rates low. Investors are afraid that a slowdown in Fed buying will reverse that trend, and so they've sold off their bonds, helping send prices lower.

To understand just how hard the bond market has been hit, the same 30-year bond that the U.S. Treasury auctioned off back in February for just under $990 has seen its value drop to less than $923, an almost 7 percent drop. Even worse, an inflation-adjusted Treasury bond that sold for $995 at auction four months ago is now available for less than $810, a decrease of about 19 percent. Losses of that magnitude are unusual even for the stock market, let alone bonds.

Those particular long-term bonds are extreme cases, but throughout the bond market, most bonds have lost significant amounts of value. The result has been a rush for the exits among bond-fund investors, with the Investment Company Institute reporting that bond mutual funds have seen net sales of more than $10 billion in each of the past two weeks, reversing the net purchases that prevailed throughout most of the past several years.

Putting Bonds in Perspective

The short-term plunge in bond prices is scary for investors. But in the context of a much longer-term bull market in bonds, the recent declines have barely made a dent in the returns that many bond investors have reaped.

More than 30 years ago, the bond market was in shambles, with double-digit inflation eroding the purchasing power of the U.S. dollar at an alarming rate. In order to compensate for the risk of owning long-term bonds, the U.S. government had to pay interest rates of as high as 14 percent on 30-year bonds, according to figures from the Federal Reserve Bank of St. Louis. After that crisis ended, rates came down significantly, but 30-year bonds still typically paid between 5 percent and 9 percent.

By contrast, as recently as last summer, 30-year bonds yielded just over 2.5 percent. The combination of high income and falling rates helped bonds return an average of 11.5 percent per year from 1981 to 2011, according to figures compiled by Bianco Research.

Wharton School Finance Professor Jeremy Siegel said that the 30-year period was the first since the 19th century that bonds had beaten out stock returns over such a long time frame. In that light, the recent run-up in rates to around 3.5 percent, while sudden, is only a minor move.

Nevertheless, what it does show is how you have to be aware of all parts of your investment portfolio in assessing risk, not just the ones you identify as high-risk.

What to Do Now

Although the rise in interest rates isn't surprising in itself, the rapid rate of that rise wasn't what most bond experts had expected. Given just how low rates had fallen, further rises would still leave rates below their long-term historical levels. In other words, you can't assume that we've already seen the bulk of bond-market losses in the near-term.

Still, reacting emotionally to the plunge in bonds would be just as big a mistake as overreacting to past stock market crashes has been.

Instead, take the time to assess whether your overall risk tolerance is compatible with your current allocation to bonds and stocks. If you find yourself out of balance, then tweaking your exposure across different financial markets could leave you with a more comfortable ride going forward.