Tuesday, October 27, 2020

Bonds Are Built on Trust

ASK THE CFP® PRACTITIONER


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“The bonds of matrimony are like any other bonds, they mature slowly.” ~ Peter Drucker, often referred to as the founder of modern management (1909- 2005).

Question: Should I be worried about a bond market bubble?

Answer: Before we choose whether or not to be worried, lets’ define what a bubble means in the financial industry. Bubbles represent overly inflated asset values. The root cause of this may be attributed to excessive and exuberant behavior, not always based on factual support. Examples are when speculators flocked to dot-com companies in the late 1990s and into real estate during the early 2000s. Prices became frothy in these overheated markets. Bubbles tend to burst when logic returns. Eventually pricing returns to reality and is again based on fundamentals rather than emotion.

 

 

Bonds, Dot-Coms and Real Estate In finance, or in friendship, a bond is a pledge or connection based on trust. Bonds are different than dot-com stocks or real estate. Issued by corporations or government entities, bonds represent a loan and have a stated maturity date. Investors receive interest income during the course of the agreement. Interest is the cost of borrowing funds with higher rates indicative of more risk.

Bond quality depends on the creditworthiness of the underlying issuer. Unless the issuer defaults, the bond’s face value will be returned at maturity. This is a major difference between bonds and other investments.

FEAR: False Evidence Appears Real The four most dangerous words in finance are “this time it’s different.” If a bond sell-off occurred, prices would go down and yields go up. This is due to the inverse relationship between bond prices and interest rates. Yield depends on the price paid for a bond and illustrates the risk/reward relationship between the cost of money and the return earned on an investment. In the absence of defaults by bond issuers, individual bonds would perform exactly as intended from date of purchase to maturity. Interest income and face value repayment at maturity would likely remain the same. Terms for most bonds don’t change even if there’s interest rate volatility

during the holding period. Bond funds carry a different risk since valuations are tied to net asset value, which may or may not be affected with interest rate volatility.

Show and Tell To illustrate how bonds work I have a visual aid in my office. While visiting a Civil War Museum in Paducah, Kentucky my husband bought me an authentic Confederate States of America Cotton Bond certificate with all but one of its interest coupons attached. The bond was issued in 1863 to help finance the Civil War. Coupons could be presented by the owner for interest payments or redeemed for cotton, which was known as “white gold” at the time. The certificate exemplifies that in extreme instances bonds may become worthless, except to someone like me who appreciates the historic value and illustrative use. Bond investors who hold bonds to maturity

can generally ignore the effects of interest rate volatility. Return of face value at maturity is an important concept when evaluating the validity of bond bubbles. Most investors buy bonds for a steady stream of income and for preservation of capital with return of principal at maturity. The price of an individual bond while held is of minimal consequence to most investors although the quality of bond issuers does matter.

Don’t Believe Everything You Hear There are irresponsible statements being made in the media to frighten investors about potential bond bubbles. Phones, laptops, and televisions are now all potential sources of anxiety. CNN reported that the average adult in the U.S. spends more than ten hours each and every day in screen time. Headlines and commentators can easily disrupt long-term investment strategies, steering investors away from fundamental realities. Media opinions may lead to irrational behavior because we easily forget that over time, markets are resilient. The most common benchmark for bonds is the Barclays US Aggregate Bond Index. Since it began in 1980, it has never declined more than 2.9% during any year, and only three times since then have bonds produced a negative rate of return. External interest rates will likely change, that’s a given. The rate of change and the amount depend on a number of economic factors. By diversifying bond maturities investors can reduce the impact of interest rate changes by owning various maturities with principle returned at different times creating opportunities to reinvest those amounts at the current rate. Understanding bonds and for that matter, all of your investments and how they work may reduce apprehension and worry about things like a bond bubble. Know what you own and why you own it. Stay focused and invest accordingly.

Past performance does not guarantee future results. All investments are subject to risk. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. This information should not be construed as a recommendation of any investment strategy or product. Views expressed are the current opinion of the author and are subject to change without notice. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. There is no assurance these trends will continue or that forecasts mentioned will occur.

“Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER ™, CFP® (with plaque design) and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.”

The Barclays Capital US Aggregate is an unmanaged market value weighted performance benchmark for investmentgrade fixed rate debt issues, including government, corporate, asset backed, mortgage backed securities with a maturity of at least 1 year. Investors should consider the investment objectives, risks, charges and expenses of an investment company carefully before investing. The prospectus contains this and other information and should be read carefully before investing. The prospectus is available from your investment professional.

This article provided by Darcie Guerin, CFP®, Vice President, Investments & Branch Manager of Raymond James & Associates, Inc., Member New York Stock Exchange/SIPC, 606 Bald Eagle Dr. Suite 401, Marco Island, FL 34145. She may be reached at 239-389-1041, email darcie.guerin@raymondjames.com. Website: www.raymondjames.com/Darcie.

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