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Bond market 101

Posted September 04, 2013 in Adel, Advice Column

Recent developments in the bond market have left unsuspecting investors in a state of fear and confusion. Many had been under the impression that bonds are “safe” investments and had placed a large chunk of their retirement savings in them since being burned by the stock market collapse of 2008-2009.

While it’s true that bonds have historically been more stable than stocks, they are subject to the same law that rules every market — supply and demand. As we saw in May and June, when sellers greatly outnumber buyers, prices go down — in a hurry. Many bond investors who had enjoyed the historically outsized returns of the last few years failed to realize that those returns were made possible by the fact that non-government bond prices had crashed along with the stock market in the last financial crisis, and their recovery was enhanced greatly by the Federal Reserve’s low interest rate policies.

So, what caused the reversal in the bond market? Contrary to what the financial media would have us believe, nobody simply stepped up on the podium and announced that interest rates were going to start rising, thus setting off a spate of bond selling. In fact, the cause-and-effect relationship is the opposite — the selling of bonds is what causes bond yields (interest rates) to rise.  So the question du jour should be “what caused Wall Street to start dumping bonds?”

In a nutshell, Wall Street believes our economy is incapable of functioning without the Fed’s easy money policies in place. When the Fed hinted that its current policies won’t continue forever, Wall Street threw a temper tantrum like a child who is denied a third dish of ice cream at bed time. The traders’ convoluted reasoning goes along these lines — “if the Fed stops feeding the market easy money, interest rates will go back up (to normal levels) and company profits will dry up and we don’t want to own bonds if that comes to pass.” So Wall Street dumped bonds in May, Mom and Pop heard about it on the news and saw the impact it had on their account value, and followed suit in June and July. Portfolio managers were forced to sell good bonds at bad prices to redeem nervous investors’ funds, and the rout was on.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and vice versa. The lesson of the last quarter is that bonds are not inherently “safe” investments, at least if we equate safety with maintaining a stable value at all times.

Steve Conard is a Certified Financial Planner™ professional with Compass Financial Services, a registered investment advisor with offices in West Des Moines and Adel. Securities offered through LPL Financial, member FINRA/SIPC. Compass Financial Services is not an affiliate of LPL Financial.

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