Every weekday evening, you probably watch some earnest newscaster telling you the stock market was up or down, quoting the Dow, the S&P, and the NASDAQ closing prices. But, he seldom mentions the much larger bond market. Jim Cramer of CNBC describes the world of investments as an ice cream sundae, with the cherry on top being the stock market and the much larger bowl of ice cream underneath being the bond market.
The stock market and the bond market really are different animals, driven by their own fundamentals. The traditional view is that investors flee to the "safety" of bonds, when they get scared of the more risky stock market. There is a push-pull of risk between stocks and bonds. Buy stocks when you are bullish, and buy bonds when you are bearish.
When investors flee the stock market, they compete to buy the available bonds, paying more for the bonds they want. Since the interest payable on the bond is fixed when issued, higher prices mean lower yields. Some economists see falling interest rates as evidence that investors have become bearish, recommending additional stimulus. Frankly, that is an over-reaction.
The problem with bonds is that they are so unique and individualized. Each is like a commercial banker making a business loan, with all the attendant covenants and warranties. While there are about 15,000 different stocks, there are about 14,000,000 different bond issues. Each is unique, making the purchase of individual bond issues very technical! For this reason, most investors prefer to buy the expertise available in mutual funds composed of bonds.
The most important general rule to remember about bonds is that their market value drops when interest rates increase. That makes sense, since new buyers will not buy the older bonds with lower interest rates unless they can buy them cheaply. The fixed interest payment divided by the new purchase price will pay about the same amount as current interest rates available. Plus, the longer the average maturity, the bigger the drop in market value.
With an individual bond, you can always hold it until maturity and get the face amount as repayment. That is not the case in a mutual fund composed of bonds. You can lose a lot of money buying a long-term bond fund . . . a lot!
Yesterday, I attended a lecture on the portfolio disclosure practices of fund managers and was appalled at the intentional obfuscation. Many of those managers are intentionally making it so obtuse and complicated that nobody can understand them. At a minimum, I would never buy a bond fund that was not rated at least a four star by Morningstar. And, in the current interest rate environment, I would never buy a long-term bond fund.
