Dave Sather's Money Matters: Does fixed income fix investor worries?
The last 10 years have seen stock market indices go nowhere. Although I constantly preach patience when investing, 10 years is a long time to get nothing in return.
This "rearview mirror" mentality, along with a variety of world problems, has led many to blindly run to fixed income assets to seek shelter.
In 2009, investors put $375 billion into bond funds, about 14 times more than in 2008 and more than double the previous record in 2002.
In the first half of 2010, investors put another $138 billion into bond funds, an astounding of the total invested in mutual funds.
This buying spree has sent bond yields plunging to historic lows. Is this a good move - or are you jumping from the frying pan into the fire?
If you buy a 10-year U.S. Treasury bond, you are loaning the government money for 10 years and, in return, they will pay you a whopping 2.67 percent per year (before income taxes). However, if the government does not default, at the end of 10 years you will get your money back. That assumes you hold that investment to maturity.
However, many investors do not hold to maturity. Furthermore, many fixed income investments are held through a mutual fund - in which case they do not have a fixed maturity date for repayment of their investment.
If interest rates move up, fixed income investors may find a nasty surprise. Fixed income assets trade each day, just like the stock market does. The pricing is mainly determined by the credit quality of the issuer, time to maturity and interest rates.
If interest rates go up, fixed income investors will see their assets drop in value. We saw a perfect example of this when a recent 10-day period saw the 10-year Treasury bond lose 2.5 percent of its value. That means that in 10 days, an investor saw almost a years' worth of interest evaporate. Now that seemingly safe investment does not seem quite so safe.
For the last 30 years interest rates have been dropping. A little common sense should make an investor realize that rates cannot, and will not, fall forever. At some point, this long term trend will begin to reverse, exposing many fixed income investors to unanticipated risks.
Given this, what is an investor to do?
n First, do not invest with only a rearward perspective. Just because certain things have happened in the past does not mean they will happen in the future. The odds of interest rates continuing to fall are quite low and the odds of the stock market falling over the next 10 years are also quite low.
n Secondly, match needs with maturities. For instance, if you have a child who will need college tuition paid in two years, buy an individual two-year fixed income asset instead of a fixed income mutual fund. You won't earn much, but the money will be there when you need it.
For long term needs (10 or more years), the stock market probably provides the best opportunities if you can stomach the short-term volatility.
n Finally, correctly matching your time frames with your investment decisions will help guide you to effectively and appropriately manage your assets.
Dave Sather is a Victoria Certified Financial Planner and owner of Sather Financial Group. His column, Money Matters, publishes every other Wednesday.