Do You Own Government Bonds?

| February 23, 2010

I’ve got a confession to make.  I don’t own bonds in my portfolio.  Tragic, isn’t it?  Now most professional financial advisors would say I’m committing a sin of the worst kind.  In most retirement programs, bonds play a key role in adding stability to a portfolio.

Bonds are what the pros call inversely correlated.

That’s a fancy way of saying when the stock market goes down, bond prices often go up.  So you can imagine the impact it has on your portfolio.  If all you own are stocks, your portfolio will fluctuate like a roller coaster.

By adding bonds, you smooth out the highs and lows.

Bonds are the great stabilizer.  When the market tanks, you lose less money… however, when the market rallies, you also make less money. Don’t get me wrong, you still capture your interest payment from the bond, but it’s nothing like what you could make in stocks.

For example, if the market rallies 10%, your bonds are going to stay stable (or might fall a tiny bit)… and that puts a drag on the overall performance of your portfolio.

I recommend almost everyone own bonds.

Why don’t I own bonds?

The simple answer is… because I’m young.  I still have several decades before retirement.  And I feel comfortable taking on the additional risk. Also, just because I don’t own them now doesn’t mean I won’t ever own them.  I’m planning on adding bonds to my portfolio in a few years.

But, I am opposed to owning government bonds right now.

And it’s important for everyone who owns bonds to understand why.

First, let me say this… if you own bonds in your portfolio, congratulations on doing the smart thing.  Being diversified is never wrong.

However, listen to my warning.  I’m worried about bond prices because of current yields.

If you own domestic bonds (like US Corporate bonds or Government bonds) be prepared to see them fall in value in the next few years.

This I’m certain of.

Bond prices move inversely with interest rates… so when rates fall, bond prices rise.  No doubt you witnessed this during 2008 and 2009.  That’s when the Federal Reserve cut interest rates from 5.25% to less than 0.25%, a level never before seen.

Here’s the kicker, the Fed Funds rate can’t go much lower…

Eventually the Fed will need to start increasing interest rates.  They recently took a baby-step towards higher rates by increasing the cost of borrowing from the discount window.  The details aren’t important… what you need to know is it’s a major change in direction for the Fed.

It’s the first step toward higher rates.

I wouldn’t be surprised to see a Fed Funds rate increase before the end of the year.  Remember, when the Fed increases interest rates, bond prices will start to fall.

Does that mean you should dump all your bond holdings?

No, of course not.  It means you should just start watching your longer term bonds.  Consider lightening up a bit on your holdings.  Don’t sell everything… just take a little off the table.

Shift some of your bond holdings from longer term bonds to shorter term bonds.  You might also look at employing a laddered bond portfolio.  Simply buy a number of bonds with various maturity dates from short to very long term.

Most investors use laddered portfolios as a way to manage interest rate risks.

Remember, it’s not “IF” but “WHEN” the Fed starts to raise interest rates… and when that starts happening, bond prices are going to fall… and fall hard.  Protect yourself now.

Tags: , , , , ,

Category: Bonds

About the Author ()

The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

Comments are closed.