These days, many investors are focused on the volatility of the stock market. But if you own bonds, you’re probably looking at a different picture. In fact, bond prices have risen so much that there’s now talk of a possible “bubble.” If this happens — that is, if bond prices reach unsustainable levels and then drop sharply — how should you respond?
Before we consider the likelihood of a potential bubble, let’s look at just why bond prices have risen so much. The chief cause is falling interest rates. When market interest rates decline, the price on existing bonds — which may carry higher rates — will rise. That’s because investors, seeking higher interest payments, will be willing to pay a “premium” to purchase those bonds. Bond prices are also being pumped up by the huge infusion of cash into bond-based mutual funds, spurred, in part, by investors’ concern over the stock market’s performance.
Now, let’s return to the issue of a potential bubble. It’s almost impossible to predict such an event, but some factors would seem to lessen its likelihood. Although past performance is no guarantee of future results, bond declines historically have been less frequent and less severe than stock plunges. Also, while interest rates will rise eventually, they appear poised to stay relatively low for a while. Furthermore, as investors remain somewhat pessimistic about the pace of the economic recovery, they may continue to be leery of the stock market, choosing instead to continue putting money into bonds, thereby helping keep prices high.
Ultimately, though, even if a bond bubble were to occur, it wouldn’t necessarily have a major impact on your investment success. —Here are a few things to consider:
•Hold bonds until maturity. If you buy bonds for the income they provide, there’s typically no need to sell them prior to maturity. No matter what happens to the market value of your bonds, you will receive the same regular interest payments. And when your bonds mature, you’ll receive all your principal back, unless the issuer defaults — an unlikely event if you purchase “investment-grade” bonds.
•Build bond ladders. You can’t always anticipate changes in interest rates, but you can prepare for them by building a “ladder” of bonds of varying maturities. When market interest rates rise, you can reinvest the proceeds of your maturing, short-term bonds into the new bonds being issued at the higher rates. And when market rates fall, you’ll still have the higher rates of your long-term bonds working for you. (Generally speaking, longer-term bonds pay higher interest rates than shorter-term bonds; this is to reward investors for the greater risk, and built-in inflation expectations, of the long bonds.) Be sure to evaluate the securities held within the ladder to ensure they are consistent with your investment objectives, risk tolerance and financial circumstances.
•Diversify. Of course, you don’t want to invest only in bonds. Try to build a diversified portfolio based on your goals, risk tolerance and time horizon that could include bonds, quality stocks, certificates of deposit, government securities, bond funds and other securities. Keep in mind, though, that diversification, while helping reduce the effects of volatility, can’t guarantee profits or protect against loss.
Whether or not we see a bond bubble, these moves can help you — so give them a place in your overall investment strategy.