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Bonds are boring, but should you own them?

Bonds are boring, or so the saying goes. In theory, you can tuck them away, forget about them, and receive a predictable cash flow over a period of time. But bonds have risks, as do all investments, and sometimes they are more volatile than stocks.

Credit risk

The price of a company’s bond in the marketplace fluctuates with its ability to repay the principal amount. As the company’s financial position gets weaker, investors will demand a higher rate of interest. Conversely, if the company’s financial position becomes stronger, investors will require a lower interest rate.

The price of a bond is inversely proportional to its yield. If you buy a bond for $1,000 at a rate of 3.0% and the company becomes more risky, the market rate of the bond drops, and the yield correspondingly rises. This only affects the you if you want to sell the bond because the company is still obligated to pay the principal amount of $1,000. However, the secondary market prices-in the credit risk and other factors, which cause the market rate of the bond to fluctuate in value.

If a company that issues a bond loses the ability to repay the principal amount, the bond can lose much of its value. Rarely does the value go to zero because, even in a liquidation bankruptcy, assets of the company can be sold to pay-off part of the bond's principal. For a given company, there is also a hierarchy that determines which bonds pay the most in the event of liquidation.

Interest rate risk

Bond prices fluctuate when interest rates change. If a $1,000 bond of an investment grade, or safe company, is yielding 2.0% and interest rates rise such that similar bonds are yielding 2.5%, the price of the bond will drop in the marketplace. The company must still pay the $1,000 principal, or par, amount of the bond, but the ability to sell it at that price in the secondary market diminishes.

Until December 16, the Federal Reserve had kept interest rates at near-zero since December, 2008, which was the height of the financial crisis. The target rate for short-term interest rates was raised to a range of 0.25% to 0.50%, and the Fed has telegraphed its intent to continue raising rates in 2016.

It is possible that short-term rates could rise to 2.00% by the end of 2016. Even though the Fed only targets short-term rates, its actions spread throughout the yield curve, affecting longer-term rates as well. Accordingly, a series of rate hikes by the Fed will likely decrease the market prices of bonds already issued. Bonds with short maturities will be affected most, but longer-term bonds will also be affected.

Liquidity Risk

When markets are in turmoil, cash is king. In a panic, the market for bad assets dries up, and investors sell their best assets to raise cash. Accordingly, this fire-sale process reverberates through all asset classes, both safe and risky.

If you’re going to buy a bond and hold it to maturity, you might not be worried about your ability to sell it in the marketplace. However, large corporations typically hold a portfolio of bonds, and, according to accounting rules, they must reflect hypothetical profits and losses on those bonds based on current market rates.

In 2008, even short-term U.S. Treasurys, which are considered safe-haven assets, suffered declines during the worst of the market rout. Nevertheless, corporate treasurers tend to play it safe and load their accounts with government bonds. This means that in a financial panic, bond market liquidity affects the bottom line of all large corporations.

On December 9, 2015, the manager of Third Avenue Focused Credit Fund announced that it would suspend investor redemptions for at least one year, as the fund's net asset value had dropped by nearly 50% from its peak. This roiled credit markets, and yields on risky high yield bonds surged, causing a concomitant drop in their prices.

The event was significant enough for Federal Reserve Chair Janet Yellen to weigh-in on the issue at her press conference following the December 16th Fed rate hike. She said the fund was over-weighted in risky energy bond bets but that the worst was likely over.

Should you own bonds, stocks or both?

As the Fed raises rates, the higher yields of new investment grade bonds will increasingly become attractive to investors. But prices of already-issued bonds will be marked down in price because of their lower origination yields.

Typically, when the Fed commences a rate-raising cycle, economic growth is strong, and the stock market continues to climb. This continues until rates become too high for risk markets to bear, which then causes risk markets to decline. The best time to own new bonds is when the Fed has finished raising rates because they will be the highest yielding bonds until the next business cycle peak.

Historical analogs suggest this is the time to own stocks, but prices of U.S. stocks languished in 2015, as the Dow Industrial and S&P 500 are relatively flat over the year.

This presents a dilemma for investors: both stocks and bonds seem to be bad bets right now. But time horizon also factors into investment decisions.

According to Gregg Fisher, Chief Investment Officer at GersteinFisher, “If you’re going to lock your money away for 5, 10 or 20 years, why do you want to be in credit over equity? The return per unit of risk on units of risky bonds versus safe bonds over long periods of time is not worthwhile…You’re better off in equities.”