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The Art & Science of Investing: Bonds

In our previous post, we explored the high-level art versus science debate that is occurring in the finance community and how it impacts equity valuations.  This post delves into some of the issues as they relate to bonds and fixed income.  And once again, here are some very insightful comments from Clif Jarvis.

Although the bond markets are multiple times larger than the stock markets, they receive far less attention. These markets are usually set by free market forces. However, today it is no secret that Central Banks are manipulating interest rates in an effort to artificially stimulate demand for loans in an effort to provoke greater economic activity. Consequently, interest rates are at 100-year lows. These Central Banks need to hold interest rates down to avoid paying higher rate payments on the ever-increasing mountain of government debt. Currently, this debt is currently over 100% of the entire nation’s GDP (If interest rates were to rise, interest payments on the debt alone could consume the entire amount of taxes that are paid).

The plan of the Central Banks around the world is to create new money, buy bonds, and keep interest rates low until the economy revives (Quantitative Easing). Inflation will then pick up along with higher wages. Deficits will subside due to higher taxes from a growing economy. Total debt will shrink relative to a larger economy and interest rates could slowly rise to free-market levels. Again, politics influences economics and politics cannot be reduced to computer models.

For the average investor, duration and must be considered. Duration is a very important concept for bondholders. It measures the degree of risk of principal loss should interest rates rise from our current historic very low levels. For example, if interest rates rose by 1%, an investment-grade bond with an SEC yield of about 2.4% and duration of about 6 years could lose about 6% of its market value.  Given the meager 2.4% SEC yield that is not much reward for that much risk. Currently, government policies are holding interest rates at depressed levels. Should interest rates rise, many investors would be left with unexpected losses.

Given the potential explosion of future events, a human element is needed. It has become increasingly obvious that some things are not reducible to mathematical equations. Investment planning is an art that requires a human touch not just mathematical science.