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How Safe Are Bonds in a Low-Interest Environment?

Interest Rates Have More Room to Rise

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Many investors in the stock market use bonds to offset the volatility of stocks. Bonds and stocks tend to move in opposite directions, so when stocks are going down, bonds usually increase in value.

However there's always a question in a low-interest environment whether bonds are truly a safe investment for investors it the stock market.

The reason for this is low interest rates will not stay that way forever. At some point they will begin to rise and may rise dramatically if inflation appears to be an issue threatening the economy.

When interest rates rise, the value of existing bonds declines so this makes it problematic for investors to count on bonds as a safe haven.

The thing to remember is that there are two types of investors who buy bonds. The first type of investor plans to buy and hold a bond to maturity and is really concerned with the security of the principal and growth or income is a secondary priority.

The other type of bond investor buys and sells bonds much as she would stocks. Bonds trade in the secondary market as stocks do and many investors find trading bonds can provide some degree of profits if they guess correctly about interest rates.

For the conservative investor, bonds are safe havens for their principal.

For example if you bought a two-year Treasury Bill with a $1,000 face value at the end of two years, no matter what interest rates have done, you will get your $1,000 back. The same could be said of highly rated corporate or municipal bonds but they lack the same guarantees as U.S. Treasury issues.

By the same token, you can invest $1,000 in a stock and two years the value of that investment may be more or it may be less than $1,000. Investors looking for growth also focus on stocks as the place they need to look.

Investor interested in growing their invested capital often place their money with stocks, which have the potential to gain value over time, but also the potential to lose money.

Of course, bonds can also gain value over time if interest rates decline after the bond was issued. However in a low-interest environment it is safe to assume that most of the pressure is going to be for interest rates to rise. When this happens existing bonds can lose value because the dividends they pay will be less than what a new bond could offer in the higher interest rate environment.

If you are in or approaching retirement your primary concern is to keep pace with inflation and preserve capital. Bonds can accomplish one of those two tasks but not the other.

If you select Treasury bonds or highly rated corporate or municipal bonds you can be fairly certain that your bonds will be worth their face value. The same cannot be said for stocks since the value of stocks varies depending on market supply and demand for that particular issue.

Still, investors in bonds face the risk that before their bonds mature interest rates will rise in the value of their bonds will decline accordingly. If you plan to hold to maturity, this is not much of an issue.

However if your plan was to sell the bond at some point, then investing in bonds in a low-interest environment takes on a higher degree of risk.

To sell a low-interest bond in a higher interest environment means you have to discount the face value of the bond so that the interest rate on the old bond matches the current market interest rate. This is the more likely outcome in a low-interest environment when there is little room on the downside for interest rates to fall further but a lot of room on the upside for interest rates to rise.

In summary, if your goal is to preserve capital over a stated period of time the high-quality bond held to maturity will probably fit your needs. However you will have to be happy with a lower return as a trade-off for the safety bonds offer.

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